Credit Cards

Prosper is a marketplace brimming with woe. In this respect it is not so different from a dating site, except that on Prosper people are looking for money, which is immeasurably more useful, and often harder to come by, than love. Love will sometimes find you in the dark when you least expect it, and change your life. This almost never happens with money. If you aren’t born with it, there are really only two legitimate ways to get it: You work for it, trading your time and effort, or you borrow it, putting on the line your reputation, assets and future income. For vast numbers of Americans today, the first option simply isn’t working out, and the second choice — borrowing — has become a way of life. The problem isn’t just record debt, but also the terms. Credit cards offer rates that are fluid and unpredictable, with high fees and little sympathy for hardship. Worse still are payday loan centers, which lend out money at obscene rates — 400 percent or more on an annual basis — yet have become a necessary crutch for many.

Prosper bills itself as an Internet-age alternative to such creditors. The system, which has been in operation since February, is at once ingenious and faintly surreal; its premise is that strangers — lenders and borrowers — will come together to execute meaningful, serious and risky transactions in a self-consciously anonymous environment, not unlike the way buyers and sellers do business with each other on eBay. If they succeed, “person-to-person” lending sites like Prosper — competitors are coming online soon — could upend the credit industry, bringing transparency and fairness to a market not known for either. Borrowers who’ve been shut out of the loan market find money at reasonable interest rates, and people with money to lend get a return that can surpass that of other investments. Prosper, which manages the loan, takes a small cut of the deal. (Borrowers pay 1 percent of each loan and lenders pay .5 percent on the money owed to them.)

There is much to question about this setup. Critics and skeptics wonder about the risks involved for both borrowers and lenders, the site’s adherence to equal-opportunity regulations, and, most important, the very logic behind its operations, the idea that people with money will actually lend to people in need, especially to borrowers who have poor financial records. Yet the idea sounds intuitively attractive to many who follow the credit industry and are familiar with its pitfalls. “Looking at it from 10,000 feet, this is a great idea,” says Elizabeth Warren, a professor at Harvard Law School who’s an expert on bankruptcy law. “It could have the wonderful effect of making markets work the way they should, driving down the amounts charged for loans to the true marginal cost.”

Warren suggests that Prosper is much more than a novel Web site — it’s an example, she says, of one of the ways the Internet might transform the credit industry into a fairer, more equitable business. “There are things going on in the lending industry that if it were transparent would never occur,” she says. At least in theory, sites like Prosper hold the potential to free many in the middle class from the stranglehold of credit card debt and to give low-income Americans a way out of the debt traps laid by unseemly payday loan centers.

Another intriguing possibility is that Prosper can help instill financial discipline in people who’ve had trouble with money all their lives. Warren points out that one of the questions that people who study debt and bankruptcy in America wrestle with is “whether anyone should be lending money to people who are already in financial trouble.” The answer would seem to depend on the borrower. For some people in debt, a little bit of money offered at a reasonable rate can set the world right again, while for others, as a wise man once said, mo’ money, mo’ problems. But determining which borrowers can be saved from those who are simply undisciplined is a labor-intensive task, and mainstream creditors — credit card firms and payday loan centers — hardly make the effort. They charge everyone a high rate with the expectation that some will default, and others will live forever in lucrative, revolving debt.

The virtual world of Prosper offers a far more personal experience. Trading money on the site is an intensely social activity, in which lenders sit in constant judgment of the most intimate aspects of borrowers’ lives, scrutinizing their financial histories and making public guesses about their responsibility. Successful borrowers, meanwhile, must convince lenders to part with their money, not only by disclosing their finances, but by pleading their cases directly, promising to work harder at managing their money.

And the process seems to be working. Many of the lenders on Prosper, for instance, know almost nothing about BusyLady52, not even her name (which she asked me not to publish). What they do know about her (a middling credit score, a couple of current delinquencies) is the sort of thing that would render her ineligible for a traditional loan. Yet lenders saw in her story some spark of genuine responsibility, a possibility that she’d do well if given a chance. More than 50 people got together to give her a total of $5,000 at a 16 percent rate. She now says she’s determined to set her money straight again, if only to prove herself to those who invested in her. “Grateful?” she says. “When I got up this morning and saw the money in my account — oh, you have no idea.”

Late in 2003, Richard Duvall, a technology entrepreneur in the U.K., left Egg, the world’s largest online bank, which he had founded in 1998. At the time, he says, he had more money in the bank than he’d ever had in his life. To the credit bureau, however, Duvall apparently looked like a risk. “Two days after I left Egg, I went into a cell shop, and after spending two hours choosing a phone, I went up to the counter and said, ‘I’d like this one,’” Duvall recalls. The sales clerk asked Duvall a series of questions to assess his credit-worthiness: Was he employed? How long had he lived in his home? (As it happened, he’d recently moved.) The answers were not satisfactory. “They said, ‘We can’t give you that phone. You don’t meet our requirements for a loan.’”

Duvall’s story expresses the idea that animates person-to-person lending: Good people are being overlooked. Traditional creditors use a trove of data to assess us all, thoroughly scrutinizing our financial records and giving each of us a score. But because these scores are determined by algorithm rather than human beings, they invariably miss important aspects of our financial lives. In Duvall’s case, the mobile phone shop’s credit program overlooked the money he had in the bank.

For Duvall, the cellphone incident was a spark of inspiration, one of the reasons he hit upon the idea for Zopa, a person-to-person lending site that opened in the U.K. in March 2005. Duvall, who’s now the CEO of Zopa, says the firm now has 70,000 members, and has made millions of dollars in loans. A U.S. version of the site will open this summer, serving, at first, only California.

On Prosper, it’s common to find borrowers who claim that traditional credit agencies have overlooked some meaningful measure of their finances. To put up a loan listing on the site, borrowers determine the amount they’re looking for and the maximum interest rate they’re willing to pay. (You can borrow up to $25,000 on Prosper; depending on what state you live in, you might face a minimum loan amount as well.) Borrowers give Prosper a few bits of personal information — annual income, bank account number and Social Security number — and authorize the site to collect financial data from credit agencies. Prosper shows potential lenders the data it collects, including a credit grade, the number of credit lines the borrower has opened in the last decade, the number of delinquencies he’s had, and his ratio of debt to income.

Often, though, borrowers will argue that these numbers don’t tell the whole story. Sometimes, they have a point. If I told you about Person X, who had a credit rating of H.R. — “high risk,” the lowest rating — a string of recent delinquencies, and a 20 percent debt-to-income ratio, you’d probably conclude that she was heading straight to bankruptcy. Lending this person money would be about as profitable as throwing it into a fountain and waiting for your wish to come true. But what if I also told you that this person, Suzy, had accumulated her debt while she was studying at Harvard Law School? And what if I mentioned that she had just graduated with honors, and had accepted a job at a Manhattan firm with a starting salary of $140,000 a year? She only needs a loan to tide her over until she starts work. Now I tell you that she’s willing to pay a 20 percent interest rate on your money. Would you take a risk on her now?

To be sure, things on Prosper, as in real life, are not always so clear-cut. You won’t usually find the Harvard Law student with a guaranteed future salary looking to pay a high rate for a loan. But there are many whose future incomes look assured, and who appear to be much better credit risks than the numbers would suggest. William Bulck is a 26-year-old student in Milwaukee, Wis. Prosper gives Bulck a credit grade of C, which is about average; according to Experian, a credit reporting agency, there is a small but not insignificant chance that someone with this credit score will default on a loan. Bulck has a debt-to-income ratio of 10 percent, which is not terrible, but not great either. When Bulck went in search of a traditional bank loan to help him pay his way through school, he met with one rejection after another. “I have a friend who is a bank manager, and when I talked to him, the first place he said to try was Prosper.”

Early in May, Bulck put up a request for a loan of $2,800, offering an interest rate to lenders of 13.9 percent. “This loan is probably the hardest thing I have had to ask for in a very long time, and I appreciate your help,” his listing began. Bulck went on to describe his situation. He receives financial aid, he said, but his next disbursement doesn’t come until August, and he’d have a hard time until then. But he assured possible lenders that his future looked bright. He’s in his last year of school, and he expects to find a job soon. “I don’t anticipate any problems paying this loan back,” he wrote.

Despite his assurances, a risk-averse investor would have found much to be wary of in Bulck’s listing. His chosen field of study is creative writing, not a major known for the swiftness with which it places graduates in steady employment. There’s a more basic problem, which is whether you can trust him. Bulck posted a photograph — he’s seated at a desk, writing, a cat perched nearby — and though he looks decent enough, it would have been impossible for any lenders to know for sure that Bulck was really a student due to get a financial aid check in August, and was not, instead, just practicing his creative writing to get some quick cash.

As it happened, people believed Bulck’s story, and he got his loan. But that’s not the case with everyone. Lending money on Prosper is no different from lending money in real life — it’s possible, and some might say likely, that some people aren’t who they say they are, and that they won’t pay you back. Prosper is explicit with lenders about this risk, and it advises people to get around it by diversifying. If you have $5,000 to invest in Prosper, the site encourages you to spread your money among many people. Every loan on Prosper lasts for three years (borrowers face no penalty for paying the loan early). If you give $50 to 100 people who have a credit grade of C, chances are that over the course of three years, some people — about three, according to Experian — will default on their loans. But if you get a 14 percent return on your money from those who do pay you back, you’ll make more than $1,000 on your $5,000 investment, enough to cover your losses.

To understand why Prosper has the potential to become a blessed alternative for many borrowers, it helps to understand the enormous changes that have occurred in the American financial service industry during the past three decades. The story begins in 1978, when the Supreme Court handed down a unanimous decision that revolutionized the credit industry, and consequently laid the foundation for the dismal state of American households’ finances. In Marquette National Bank v. First Omaha Service Corp., the court essentially invalidated state usury laws — the laws that set a legal limit on the interest rates banks could charge for credit. The court decision allowed companies like Citibank to provide Americans with credit cards at sky-high rates, a deal that proved attractive both to customers, who were willing to pay for what looked like easy money, and to the bank corporations, which cashed in on the appetite for credit. (The PBS program “Frontline” has put together an excellent history of the industry.)

Some economists argue that the surge in easy credit was good for the economy, as Americans began to spend at an increased pace. But the rise of credit cards also caused a consequent rise in credit debt. American consumer debt now totals more than $2.1 trillion, and it is growing rapidly. Moreover, says Michael Stegman, a management professor who directs the University of North Carolina’s Center for Community Capitalism, the credit card industry usurped the market for traditional, lower interest-rate bank loans. The unsecured loan business — that is, loans made to people who don’t put down an asset, such as a house, as collateral — dried up. “Today you can’t walk into a bank, even with good credit, and get an unsecured loan for, say, $15,000,” Stegman says. “And if you’ve got any kind of impaired credit, forget it.” Many people, that is, have no alternative but to borrow money using credit cards.

For Americans with the lowest incomes, another dangerous force emerged in the 1990s: the payday loan industry. These retail centers offer money at high cost on a short-term basis — they’ll give you cash on Tuesday in return for a promise of payback on Friday. As Jeanne Ann Fox, who studies the payday loan industry at the Consumer Federation of America, points out, loan centers don’t make the true costs of such loans clear to customers. A typical two-week loan will cost you in the neighborhood of $15 or $20 in interest per $100 in principal. For people who need money immediately — and studies show that many payday loan customers are using the cash for food and other necessities — such a fee might sound reasonable. What the loan centers don’t say is how much these loans work out to on a long-term basis. A $20 fee for a two-week, $100 loan represents an enormous annual interest rate — a 521 percent APR.

The long-term rate is important because studies show that people who take out short-term loans are often repeat customers, borrowing a steady flow of money from several payday centers over the course of a year. Twelve states currently have laws on the books that effectively ban payday loan centers; of the rest, the state that has kept the closest watch on the industry is Colorado. Last November, Paul Chessin, one of the state’s assistant attorneys general, published a comprehensive study of how payday loan centers operate in the state. Chessin found that the average payday loan customer in Colorado obtains about nine payday loans per year. In a given year, this average customer, Chessin wrote, “pays a total of $477.16 in finance charges and is indebted for a total period of just over five out of twelve months.”

People who study the payday loan industry have a name for the hole in which these repeat customers find themselves — the “payday loan trap,” or “debt treadmill,” which describes the cycle of taking on payday loans just to keep financing previous loans. Chessin found that repeat customers are quite lucrative to loan centers. In Colorado, people who borrow 12 or more times per year account for two-thirds of the payday loan business in the state. (You can read Chessin’s study in PDF format here.)

One curious feature of the payday loan business is its almost complete lack of price competition. The industry has seen explosive growth in recent years, with loan centers dotting urban and suburban storefronts across the land. In Colorado, there were fewer than 200 loan centers in 1997; by 2005, the number had grown to more than 600. Economists predict that intense competition leads to lower prices — in this case lower interest rates for loans. But Chessin found that the average APR on loans has remained virtually steady (at slightly under 400 percent). “We have not seen price competition in this industry,” says the Consumer Federation of America’s Jeanne Ann Fox. “Even when there’s a lender on every corner, you don’t find that.”

A representative for the Community Financial Services Association of America, the payday loan industry association, did not respond to my inquiries. The industry has maintained, however, that it needs to charge three-digit interest rates because it is offering extremely risky loans. This would seem to make intuitive sense — after all, these companies are lending money to people who have low incomes, and they do not take any collateral in return for the money. If a substantial number of their customers are likely to default, you’d expect payday loan firms to charge rates high enough to keep their business profitable.

But Chessin’s study undercuts that argument. He points out that between 1996 and 2004, payday lenders in Colorado reported an average “charge-off rate” — the rate of loans that weren’t paid back — of 3.34 percent. Chessin notes that this is comparable to the loss rate for most bank loans. “For the same period, the charge-off rate for all consumer loans made at commercial banks was 2.69 percent; for credit cards, it was 5.15 percent,” Chessin writes. What this means is simple: Payday loan customers aren’t deadbeats — indeed, they may be good credit risks.

All this data builds to a compelling conclusion about the credit industry today. Financial institutions appear to be making exorbitant profits from loan products — payday loans and credit cards — that are by all measures overpriced. The high interest rates are tenable only through a lack of transparency. Customers don’t really know the true price they’re paying, and don’t have any real alternative to these products. Such a market, though tremendously profitable, is ironically also vulnerable to competition from a more nimble, inventive upstart. That is exactly the role that sites like Prosper aim to play.

I met Chris Larsen, Prosper’s co-founder and CEO, at the company’s austere headquarters in a small office space on the first floor of an old building in San Francisco’s financial district. Larsen, who in 1996 co-founded E-Loan, one of the first Internet loan brokers, is an understated fellow, and when he talks about the credit industry, he doesn’t sound especially impassioned about the possibility that his company might transform it. Still, there’s no mistaking that Larsen, who has long been feted for his consumer-rights advocacy — in 2003, he spent $1 million of his own money to push California to adopt a tough financial privacy bill — is on a mission.

“My opinion of the consumer credit industry is that it works well in the formation of credit, but it’s really a problem by the time it gets to the consumer,” he says. “You have consumers being misled, it’s too expensive, not very transparent, and not very open.” He adds, “Access to credit is right up there with healthcare and education in terms of being fundamental to a society. You have so many bad things going on in the current system, so many bad things.”

Shane Garza, a 29-year-old information technology manager in Grand Rapids, Mich., might be the sort of customer that Larsen has in mind when he describes the difficulties some Americans have with credit and debt. At the same time, Garza, a serial borrower, illustrates how Prosper may not work for everyone, and how tough it can be to determine whether someone who’s made bad decisions with money deserves any more.

“My problems started with these payday loans while trying to get caught up on my rent,” Garza wrote on a Prosper loan request he posted in mid-April. Garza has an extremely poor financial record. According to the credit information on Prosper, his credit grade is H.R., he has a debt-to-income ratio of 8 percent, and he has opened 29 credit lines in the last seven years, with two current delinquencies. He posted a list of the various sums he owed to payday loan firms: Magnum Cash Advance, $700. Sonic Cash, $400. Payday 2day, $400. Mr. Cash, $300. NE Cash, $200. 10 Dollar Payday, $300. My Cash Now, $400. CPD, $300. Cash Advance Net, $500. “I have been paying the minimum amount for over 4 months and I can not take it any longer,” he wrote on Prosper. “I get paid biweekly and they take over 500 each pay period. If I can just get these consolidated, I will be in the clear.”

But this loan was not the only request that Garza had posted. From the middle of March to early May, he put up about a dozen requests, withdrawing many of them within a couple days. His story was not exactly consistent in each of these postings — he varied the amount he was requesting, varied his tone (sometimes he was terse, sometimes verbose, sometimes he was solicitous), and even changed the photos he used. In some listings he included a photograph of himself, while in others he put up a picture of a woman dressed in a tight shirt, and in one he used an image of a cute puppy. On the Prosper message boards, one user asked, “What is up with the different pictures? Some are a guy and some are a girl … what is up with that? Are you trying to go for sex appeal or something?”

For lenders, deciding whether to give money to people with bad credit isn’t easy; a poor financial record arouses all kinds of suspicions — Is this person lazy or just unlucky? — and the suspicions are hard to overcome. In many respects, Garza looks like someone who needs to be saved. Were you a lender with a deep sense of social mission, you might give him money just out of charity. But he also looks like someone who needs some serious financial discipline. Giving him more money might only make his situation worse.

“The truth is I am addicted to debt, and I don’t know why,” Garza tells me on the phone. He says he learned this fact about himself on Prosper, as a consequence of his loan requests. Each time he posted a listing, people would ask him some very basic questions about his financial life — “If you’re in debt, why do you want to borrow more money?” — that he says awakened him to the destructiveness of his behavior. The Prosper message boards are peopled with some extremely savvy financial experts, “and they make it a point to call you out on certain things you mention in your loan request,” Garza says. He spent three years in credit counseling, but it was only on the Prosper message boards that he’d learned some of the very basic facts about money — “Don’t spend money on things I can’t afford,” Garza says. He explains that he’s been paying off his various debts diligently since he came on to the site. “The fact that there’s this site changed the way I think about money. Everything I learned about money is due to Prosper.”

I don’t know whether to believe Garza’s tale of conversion-by-Prosper. It will be some time, perhaps, before it’s possible to tell whether the site made any difference to his financial life. But early in May, Garza posted his final loan request on Prosper, asking for just $1,000 at a rate of 23.75 percent. “I would like to take out this loan to help my credit. I have a very bad rating and I am not going to blame anyone other than myself for it,” he wrote. Twelve people got together and funded his loan.

At the moment, this is a rarity on Prosper — people with credit ratings of H.R. seldom find funding. Some observers think this might be a permanent feature of the marketplace. “There are some consumers who have no credit or extremely bad credit who will be hard-pressed to find anyone on Prosper who’ll take a risk on them,” says Jennifer Tescher, director of the Center for Financial Services Innovation.

Some lenders I spoke to said they were opposed to Prosper becoming a haven for people with low credit scores. They were afraid other lenders might flee if borrowers with low credit ratings continue to obtain loans and then default on their commitments. (When borrowers default, Prosper contracts with a collection agency to try to get back the money.) There is some logic to this. At the moment, the idea of trading money with strangers might sound, to many people, fairly scary, and maybe the best way to encourage lenders to put their money in Prosper would be to keep people like Garza away from the site.

Prosper has taken many measures to combat fraud and mischief. The company complies with state lending laws that set maximum interest rates lenders can get for their loans — the rate runs from a low of 6 percent in Pennsylvania to a high of 24 percent in several states; you can’t charge someone a payday-loan-comparable 400 percent rate on Prosper. Prosper is also subject to regulation by the Federal Reserve and the Federal Trade Commission, and must also comply with the federal Truth in Lending Act and the Equal Credit Opportunity Act, which prohibits racial and gender discrimination.

Larsen has faith in what he thinks of as Prosper’s main asset — the sense of community it fosters between lenders and borrowers. In fact, the site attempts to cultivate community by encouraging both lenders and borrowers to join affinity groups. On Prosper, you can declare an affiliation to any number of organizations — there are Prosper groups for Harvard alumni, for people from Guam, for Christians, for people who love Apple computers, and many more. Larsen points out that you can get better rates on your lending and borrowing if you belong to a group, but if you default on your obligations, your actions will adversely impact others in the group. This is meant to keep borrowers in line. The idea is that people who belong to a group will feel an enhanced obligation to pay back a loan to remain in the good graces of their fellow Apple users or Harvard alumni.

This sort of peer pressure has long been used as a tool to goad borrowers into paying back micro-loans in the developing world. It reflects, says Elizabeth Warren of Harvard, an axiom of money lending. “Making decisions about whom to repay when you’re in financial trouble is less about law and more about social relationships,” she points out. Every one of the Prosper borrowers I spoke to agreed on this point. They were all so grateful to the people who’d taken a chance on them that they put their Prosper loans ahead of any other debt they had to repay.

And that goes for Garza. “I swear to God, it’s been a revelation to me,” he says of his experience on Prosper. “I swear, it’s the best thing that’s happened to me on the Internet.”