Are early payoffs bad?

[replimaster]

I have seen many postings where the poster has stated they did not like early payoffs. This runs counter to my personal feelings... that most of  the profits will occur in the first couple years of the three year loan. If the borrower wishes to pay off then, I don't lose much, and I can reinvest (and therefore again realize a higher return of interest on the new loan). What am I missing that these other people see?   
 

[go4reward]

I will be happy to have loans pay off early. It is a lot better than DQ loans. I will take the pay off early anytime.

[ResearchPro]

I have seen many postings where the poster has stated they did not like early payoffs. This runs counter to my personal feelings... that most of  the profits will occur in the first couple years of the three year loan. If the borrower wishes to pay off then, I don't lose much, and I can reinvest (and therefore again realize a higher return of interest on the new loan). What am I missing that these other people see?   

The idea behind it is this: assuming you always keep those funds invested (you reinvest those paid funds immediately) you get exposure to more people and therefore more risk.
Say, you have loaned to person A. He will pay you back anyway, be he did this earlier. You take the funds and invest to person B, who defaults after a couple of months. You loose.
Generally, it's a question of risk definition. If you consider the risk of default to be in some events that trigger people not to pay, then the early payment doesn't matter because all you funds are exposed to those events all the time. However, if you consider the risk to be in choosing the right people when investing (i.e. people are "destined" to pay or to default), then more people is more risk: one person holding your $50 for 36 month is safer then 2 people by 18 months each.

[replimaster]

The idea behind it is this: assuming you always keep those funds invested (you reinvest those paid funds immediately) you get exposure to more people and therefore more risk.
Say, you have loaned to person A. He will pay you back anyway, be he did this earlier. You take the funds and invest to person B, who defaults after a couple of months. You loose.
Generally, it's a question of risk definition. If you consider the risk of default to be in some events that trigger people not to pay, then the early payment doesn't matter because all you funds are exposed to those events all the time. However, if you consider the risk to be in choosing the right people when investing (i.e. people are "destined" to pay or to default), then more people is more risk: one person holding your $50 for 36 month is safer then 2 people by 18 months each.
[/quote]

I think I understand what you are saying, Pro. (  Sorry, but my mind doesn't work like it did 50 years ago!    ). Is this what you are saying: If loan #1 is held 3 years, there is 1 chance of default in that 36 months; if the loan #2 is payed off in one month, then reinvested and loan payed off in 1 month, etc. for 36 months, then I have 36 times the chance of default as loan #1?
Dave

[foofiter]

Those are both extreme cases. I have  2 month old loan in payoff and the person said they would and they stuck to their word. I agree that lending to more people more often can increase exposure to risk of default. That also depends on the credit quality you are lending too. Over the long term with sound investment decisions and strategy it should not affect you too much. If I were that worried about defaults then I would not be lending in the first place. Its part of the game as we say.

I must say that I would much rather have early payoffs and some return than defaults and negative return any day. I have allocated a portion of my portfolio to prosper and will stick to that percentage and only add to it to maintain balance. I will of course reinvest all payments, interest, payoffs, fees, etc. I am also using this as a learning tool. Lets just hope it won't be an expensive lesson.

Foo

[ResearchPro]

I think I understand what you are saying, Pro. (  Sorry, but my mind doesn't work like it did 50 years ago!    ). Is this what you are saying: If loan #1 is held 3 years, there is 1 chance of default in that 36 months; if the loan #2 is payed off in one month, then reinvested and loan payed off in 1 month, etc. for 36 months, then I have 36 times the chance of default as loan #1?
Dave

Dave,
it's almost this, but not exactly 36 times. The math here is very much like in casino with roulette.
Say, you are betting in roulette on all numbers except 0 and 00. Then you cover 36 numbers, and don't cover 2 numbers.
Then probability to loose in one game is 2/38 or 1/19 or 5.2%. Probability not to loose in 1 game is 1 - 1/19 = 18/19 or 94.7%.
Probability not to loose in 2 games =  (1 - 1/19) * (1 - 1/19) = (18/19)^2 = 89.7%, and probability to loose in 2 games is 1 - 89.7% = 10.3%
Probability not to loose in 3 games =  (1 - 1/19) * (1 - 1/19) * (1 - 1/19) = 85%, and probability to loose in 3 games is 1 - 85.0% = 15.0%
Probability not to loose in 4 games =  (1 - 1/19)^4 = 80.6%, and probability to loose in 4 games is 1 - 80.6% = 19.4%
etc
Same thing here.
Say, probability to det default with one borrower is 10% Then probability to get you money back is 90%.
Then, probability to get your money safely in 2 loans is 90% * 90%= 81%, and 19% to get default somewhere.
Probability to get your money safely in 3 loans is 90% * 90% * 90% = 73%, and 27% to get default somewhere.
and so on.
So reinvesting 36 times probability not to get default is 90%^36=2% and then 98% that you will have a default on the way.

[replimaster]

I've got it, now! Thanx, Pro. That explanation was much easier for me to come to grips with.

Dave

[sosocratic]

I see several issues with it.

First off - paying early is a heck of a lot better than not paying.

Making a loan does involve some work - I think much more than the average borrower appreciates. I think that one reason the general prosper lender population does not do well is that they do not do the work. They seem to just wait until closing and then throw money at every loan that is funded wih a short period of time to go (most of which have already been bid down absurdly low). But if you are doing it right you have to do a lot of searching , carefully read many listings, and make many bids that go unfunded or get outbid before you get that one loan that actually passes your muster and sticks. If the person then repays the loan immediately then your profit for that time spent is extremely low. I had one loan repay after one month and I figured my profit was $1 - not worth it.

The issue of increased risk has been pretty well covered. I would say that the one month example is extreme but the point does remain.

So, basically, the earlier they pay the lower the profit and the higher the risk. I don't mind if the person pays a little early (like after 18-24 months). I figure the getting the money back at all makes up for the adverse parts. Also, part of the point is to see people improving themselves through these loans. If the idea is to help them get out of debt then you can't begrudge them too much when they pay a loan off - even if it is yours.

But I do skip over loans where they promise/ say they intend or it just appears to me that they will pay off in a short period of time. I have seen a few lenders with multiple past propser loans all paid in short order. It is clear they accept the high rates because they consider it a short term loan and know they will not be paying it for long. Maybe some good will come from the higher fees and cut down on that.

[go4reward]

Dave,
it's almost this, but not exactly 36 times. The math here is very much like in casino with roulette.
Say, you are betting in roulette on all numbers except 0 and 00. Then you cover 36 numbers, and don't cover 2 numbers.
Then probability to loose in one game is 2/38 or 1/19 or 5.2%. Probability not to loose in 1 game is 1 - 1/19 = 18/19 or 94.7%.
Probability not to loose in 2 games =  (1 - 1/19) * (1 - 1/19) = (18/19)^2 = 89.7%, and probability to loose in 2 games is 1 - 89.7% = 10.3%
Probability not to loose in 3 games =  (1 - 1/19) * (1 - 1/19) * (1 - 1/19) = 85%, and probability to loose in 3 games is 1 - 85.0% = 15.0%
Probability not to loose in 4 games =  (1 - 1/19)^4 = 80.6%, and probability to loose in 4 games is 1 - 80.6% = 19.4%
etc
Same thing here.
Say, probability to det default with one borrower is 10% Then probability to get you money back is 90%.
Then, probability to get your money safely in 2 loans is 90% * 90%= 81%, and 19% to get default somewhere.
Probability to get your money safely in 3 loans is 90% * 90% * 90% = 73%, and 27% to get default somewhere.
and so on.
So reinvesting 36 times probability not to get default is 90%^36=2% and then 98% that you will have a default on the way.

Personally, I believe each loan has its own probability. Just like calculating winning lottery. Each bet is on its own. Unless you bed two consecutive, then you multiple the two probability.
Therefore, our default calculation is the average of all default rates. That is my 2 cents.

[uioped1]

Once again, I see the statistics differently from you guys, heh heh.

I can see what you're saying, but the way I see it, the more loans you bid on, the more your portfolio should approach the default rate expected.  Yes, if you put all your money into one loan, and the all of it into the next, the default risk is geometric, as researchpro explained.  However it doesn't really make a difference whether you have the full three years between loans, or make a new one every month.  (goes back to that other discussion of whether the default rate is annualized, or not)

I see the issue as being much more the "prepayment penalty" you pay in terms of lost interest.    If we assume that you make another bid as soon as possible after a repayment, you are not being paid interest for the time it takes you to receive the money after payoff, the time it takes for the listing you bid on, and the time it takes prosper to review that listing.  At the worst case, that could be almost three weeks of no interest.

[foofiter]

Which brings up the point that if prosper paid some small interest on the cash balance people would be much happier. Even if its 0.1% its better than nothing. We all know that they are earning interest on our idle cash anyway. Share the love?

Foo

[replimaster]

True as true can be, Foo. I understans that, for the vast majority of lenders, there probably insn't much accumulated wealth in their holding funds. However, Prosper would gain alot of repect and appreciation from the lender community by crediting us with a small interest rate. As it is now, I have a sort of 'wasted investment" feeling each time I see those funds in the holding account.
It has been mentioned by others, both in this forum community and others, that Prosper seems to prefer borrowers above lenders. Be that true or not, this would be a chance for Prosper to tell lenders "This isn't so."

IMHO
Dave

[deskguy]

i haven't been a lender long enough to find too much fault with prosper but if one was fully 'lent out' there wouldn't be any cash balance. regardless, not sure i'd want a pittance of interest at the cost of a higher fee. 

[daveuc97]

All, my opinion is that a payed off early is better than a defaulted loan.  I have specific criteria for all credit rating grades that I look for when lending.  I think  I am finding the good borrowers in all credit grades (need more time to prove this out)?  Therefore, to me, anyone of them has an equal chance to default.  I currently have an "A" grade loan that has had an NSF on the second payment.  And this loan met my strict criteria.  So, I dont see a payed off loan as increasing my risk.  I see it as I got my money back and now I go back to executing my strict selection criteria for another loan.

[deskguy]

one of my first loans was for $100 and the borrower paid off the whole thing with his first payment. i made 42 cents interest. wouldn't want that to happen very often but wouldn't be too unhappy if the prepayment was at least 18 months out.