Save Invest Retire

There’s an interesting post over at The Frontal Cortex on the Psychology of Sub-prime Mortgages. It discusses scientific studies showing that people tend to choose sub-prime mortgages, even at awful rates, because the emotional reward center in the brain overvalues the short term benefits:

The best evidence for this idea comes from the lab of Jonathan Cohen. Cohen’s clever experiment went like this: he stuck people in an fMRI machine and made them decide between a small Amazon gift certificate that they could have right away, or a larger gift certificate that they’d receive in 2 to 4 weeks. Contrary to rational models of decision-making, the two options activated very different neural systems. When subjects contemplated gift certificates in the distant future, brain areas associated with rational planning (the Promethean circuits of the prefrontal cortex) were more active. These cortical regions urge us to be patient, to wait a few extra weeks for the bigger gift certificate.

On the other hand, when subjects started thinking about getting a gift certificate right away, brain areas associated with emotion - like the midbrain dopamine system and NAcc - were turned on. These are the cells that tell us to take out a mortgage we can’t afford, or run up credit card debt when we should be saving for retirement. They are our impulsive pleasure seekers, the hedonists inside our head.

The implications are far reaching, because similar behavior is seen in the difficulty people have in saving money. This seems to be an explanation for something the frugal community has always known, that it is tempting to spend money because the intellectually sensible choice offers a different sense of reward. More importantly, I think it stresses the importance of psychological and behavioral approaches to saving and debt elimination, such as Dave Ramsey’s debt snowball over a purely number-crunching view, such as paying down the debt with the highest rate first.

Maybe this will get me moving to do that debt snowball post I’ve been putting off.

That was one of the questions raised in a Get Rich Slowly post Friday morning. I happened to be the first one to respond on GRS, and part of that was because this was already a decision I had reached. My answer is HELL NO!

Your answer might be different, but then you don’t have my brother-in-law. In fact, I have “loaned” him money in the past. I did so with the expectation of never getting it back and he fulfilled my expectations. I even “sold” him a vehicle once when he was in a pinch. Apparently the agreed-upon price was $0 because that’s what I received.

All told, it only cost me around $3000, which is a pretty cheap price to pay for something that made Mrs. Argonautica happy. I suspect she occasionally slips him money on the sly as well, but I choose to look the other way for the sake of marital harmony.

So if I obviously have not had any trouble giving/loaning him money in he past, then why would I not co-sign a loan? Well, because co-signing is different than giving and:

1. I don’t want creditors calling me when he fails to pay.
2. I don’t want to be legally responsible for his debt when he fails to pay
3. I came up with a better idea last year.

Last year, in the midst of my exploring loaning on Prosper.com , I came to the realization that Prosper was going to be my response if the brother-in-law ever came to me for money again. If he goes to Prosper instead of directly to me, we both benefit. For example, I’d be willing to cover a large percentage of the loan, but other lenders would likely jump in to get a piece of the loan.

I was plannng to lay out all the benefits of utilizing Prosper in this situation, but Tom, over at Prosper Lending Review, already addressed some of the benefits of going through Prosper. Therefore my work here is done. Thanks, for the assist, Tom!

If you’re not familiar with Prosper.com, it’s a peer-to-peer lending site, so you can participate as a borrower or a lender. So far things have been pretty positive for me. Since October 2006 I’ve lent out around $600-$700 just fooling around with the process and as of today, I have only one $50 loan that looks like it’s headed for default. That one was my own fault because early on I was lending to borrowers even if they had recent delinquencies, which I learned was one of the biggest risk factors.

Rather than relying on my summary, you can check out my stats on Eric’s Credit Community, a site where you can view stats on all the Prosper lenders. It shows a general summary of what I’ve been doing on Prosper, my loans, and my bidding history.

A few months ago I enabled weekly automatic transfers to my Prosper account, which worked well, but I stopped that for now to follow the loans that I have already made and to cut back on the time drain. You can place standing orders based on criteria you set, but I don’t particularly care for them, so I go ahead and find my loans manually and that can be as time-intensive as you allow it. Eric’s Credit Community added a “What If” tab that also shows you how you would be doing if you had won all the loans you bid on. Looking at the tab, I wonder if I am setting my interest rate too high, because all the bids I missed are current.

Looking at my loans, I’m hoping to clear 15-20% even counting that one default. Hope is a good thing. I could probably absorb another default and still be doing pretty good, but after that, and the small fees Prosper charges for managing the loans, my return will begin to look less attractive. Somewhere midstream I tightened up my loan picks and began to diversify more, so I’m expecting the more recent loans to do better in the long run than the first couple I made just checking out the process.

The biggest downside I’ve seen, other than potential defaults, is that your money can be tied up on each loan for up to three years. Not a big deal if you’re ready to remain in it long term, but keep that in mind when deciding how much to place into Prosper.

Be sure to check out the high rollers on ECC, such as carrey79 and pensioner, who have more than $1.5 million invested between them. Only time will tell, but I wonder about pensioner’s loans because the ECC ROI calculator predicts that his ROI will be around 3.3%.