This is easily the best article I have read about Prosper.  They have interviewed real borrowers and lenders in Prosper, and you can really get inside their model by reading it.

Most loans are funded by dozens of lenders who bid $50 each, the minimum allowed. Prosper keeps a 1 percent loan-originating fee (a one-time $25 charge for a $1,000 loan), and bills the lender a 0.5 percent annual loan-servicing charge. Borrowers have three years to pay off the debt, with no penalty for pre-payment. Basically, Prosper is a peer-to-peer lending auction with a human element.

Source: CSIndy: The loan rangers (December 7, 2006)

The beauty of this model is that it competes with the very things that Banks cannot replicate:

• its cheap(er) for the borrower, and higher rate for the lender
• a lender who cares, cares enough to seek out the borrower, and understand the borrowers personal story
• processing costs are eliminated – replaced by people who care

I am trying to think of how Banks can compete.  This is the ultimate in disintermediation.  For now, Banks are watching and privately hoping it won’t work, but I am afraid that is unlikely.  It may evolve but it will work.  We know that because eBay had the same questions asked in 1999 – no-one is asking now.

Of course not everyone will read the entire thing, so here are some selected quotes:

• “In most lending situations, the borrower approaches the lender, putting the lender in a position of power. Prosper turns that model on its head. Here, the lenders seek out the borrowers, who set the details of their loan, including a cap on the interest rate they’re willing or able to pay”
• “Larsen calls this “libertarian paternalism.” Anyone who can clear an identity check can post a listing. And any American with $50 can bid on that listing. Lenders can assess their risk using methods such as credit ratings based on a borrower’s actual credit score. And the borrower’s debt-to-income ratio — marked with a red warning label if the ratio is high — cautions lenders against those who may not be able to afford the loan. From that point, the market is open to do what it will. Prosper is merely the tool, the venue”
• “Tales of funding someone with such dire needs can warm the heart, but Larsen is quick to clarify that Prosper is not an altruistic endeavor. We’re a for-profit company,” he says. “If we’re ever really going to take on this trillion-dollar credit market, just for unsecured credit alone, there really needs to be a model that can sustain itself, not just through charitable contributions, but through good returns on investment”
• “We believe, much like the eBay sort of mission, that most people are good, and if people are given open access to trade, good things will come”
• “Consumers need to be on an equal playing field with lenders who have that information”
• As much as they run the risk of getting screwed by traditional loans, solo borrowers on Prosper, especially those viewed as higher-risk by lenders, have a harder time getting a loan. For them, there are Prosper groups. Apple User Group, Independent Filmmakers, Funding Your Wedding, Corporate Divas, Minorities in Need of Money, Christian Opportunities — there’s a group to suit every user.
• Groups primarily act as social networks. Users apply to a group, and the group leader accepts or denies the application. Some group leaders require a meeting or phone call, a bank statement or full financial vetting. The best groups are the most difficult to join
• Larsen references the classic holiday film It’s a Wonderful Life. Back then, with small community banks, borrowed money was actually a neighbor’s money. Prosper simply cuts out the middleman. While the neighbor may be earning 3 percent interest on his $5,000 savings deposit, the borrower is paying 19 percent interest on her line of credit from the same bank, for the same amount. Meet in the middle at 11 percent on Prosper, and she pays eight points less while he makes eight points more — a win-win