Social Lending Arbitrage Steals My Attention

Posted by Madison on February 22, 2010

Social lending arbitrage. It’s the newest finance game in town. A reader, Derek, shares the details of how to pull off this fascinating arbitrage strategy. A special thanks to Derek for sharing his story with all of us!

Social Lending Arbitrage Explained

Let me tell you about my arbitrage strategy that I’ve used successfully for almost a year on both Prosper and Lending Club.

In this instance, I borrowed $10,000 using Lending Club at a relatively cheap rate of 7.78%. I say relatively cheap in that A) it was being offered to me, and B) the price tag in the form of interest was small given the fact that it was actually being offered. This is by no means free money, so your returns will be lower than if it were a no interest credit card offer, however I’ve noticed those credit card offers have disappeared with the credit crunch we’ve been seeing over the last two years, and bank lending has similarly been affected as well.

That being said, my risk appetite is somewhat greater than the average person’s, and my investments tend to reflect that. I took the $10,000 I borrowed from Lending Club, and put it right back into Lending Club (with a balance also going to Prosper as well), looking for somewhat riskier borrowers than myself. I applied $25 per lending note and spread the total notes by risk class (A, B, C, ratings, etc), taking into account current default rates by risk class to get an estimated return. Looking at all the notes I invested in, I know about 2.5% will default based on current data. But the fact that I diversified my investment into as many notes as possible will (hopefully) minimize my default rate.

A Closer Look at the Numbers

Taking all that into account, my return on investment is close to 15%, with a 2.5% default rate means my net return is close to 12.5%. I pay 7.78% on that capital, and pocket the difference (4.72%), or about $500 over three years.

Yes, this is a lot of work for $500, but not only does it add up quickly, its something that can be built off itself very quickly — the compounding returns only make my returns bigger over time. In my mind, I’m also helping people fulfill their needs by supplying them capital to accomplish their goals. If I can make money and their needs are satisfied, then everybody wins.

I do understand this game isn’t for everyone – I have enough cash in the bank to cover my debt if all my notes default (which has next to no chance of ever happening). But it is free money, and its a very fun 10-minute a week hobby.

More about Derek

I think its good to frame what I do with how I go about doing it. I’m a financial analyst at a growing company (a rarity these days) and because I look at capital flows professionally, over the last few years, I’ve picked up on a few tricks used by companies to grab a decent return on their capital, as well as increasing their capital on-hand for capital buildouts and revenue streams. That being said, I’ve modeled some of those strategies (albeit on a much smaller scale) in my personal life as well. Some with great results, others not so great.

One of those strategies is finding good returns on capital, and having capital offers come your way at a relatively cheap price.

Action Plan

Of course, Derek had me at hello on this one! I’m considering a small scale social lending arbitrage experiment at Lending Club for some reader enjoyment. However, it might have to wait until our credit card arbitrage strategy is exhausted. Either way, stay tuned for more details on social lending arbitrage!





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Comments to Social Lending Arbitrage Steals My Attention

  1. My website is still under construction, but I noticed a mathmatical error in Derrick’s assumption. His profit should be around $1,173 or $400 per year if he is getting a 15% effective interest rate on his money. Lending club takes 1%, I have set up a simple spreadsheet that I can attach, but I will explain steps to come up with the correct return.

    If you borrow $10,000 at 7.78% you will pay $1,125 in interest over 3 years. You will turn around and loan $10,000 to 400 borrows at $25 per borrower. With a default rate of 2.5%, that would be 10 loans that would default, so you would be out $250 worst case senerio. That would leave $9,750 that is earning interest at the effect rate of 15%. Over the 3 years you would earn $2,418 in interst. Here is the math:

    $2,418 minus $1,245 would be $1,173

    If he did not factor in the 1% fee that is charged to the lender, it would reduce total earnings by roughly $175 over the 3 years.

    The error occured when he subtracted the 2.5% default rate from the interest rate.

    I love the site, keep up the good work.

    Patrick

    • I too calculated the results and came up with a profit closer to Patrick’s than Derek’s.

      Here’s what I found:
      Amount loaned out: $10,000 at 15% Interest
      Service Fee: 1% of each payment
      Anticipated Revenue if zero defaults = $1,093.55
      Anticipated Profit if 2.5% default = $848.55

      In another scenario, I factored in the borrower processing fees of 2.25%. In other words, while the loan amount might be $10,000 you’re actually only going to receive $9,775. If you only loan out $9,775 the anticipated profit with a 2.5% default rate, is $571.19.

      In either case all of my calculations had a higher return than Derek’s estimate. I’d love to know if I’m missing something in the calculation. Derek – if you’re reading, can you weigh in?

      Kelly

      • Right you are guys — I just pulled up the numbers I gave Madison and did indeed back off the default rate from the ROI %, which is inaccurate. Just as a side note, I borrowed the $10k when the service fee was still 1.25%, not the 2.25% it is today, so that needs to be taken into account.

        My original model can be summarized as follows:
        Borrow 10,000 @ 7.78% — total fees: 1.25% or $125. Total interest payments over 3 years: 1,244.60. Total fees: 1369.60, or 13.70%.

        Lend 9,875 @ 15% — total fees: $119 (or approx 1% of interest/principle payments over 3 years).
        Gain on investment: $2,450
        Back off 1% Fees:
        Adjusted Gross Gain:$2,330, or 19.28%
        Back off interest:
        Net Gain: $960

        Worst case scenario assumes that I lend 10 people (2.5% of $25 investments.. approx) who never pay up — not one payment. This drops the $960 to $710, which is greater than the $500 I stated above.

        Derek


  2. How do you handle taxes while doing this? Are you able to deduct the interest you are paying in your loan from the interest you are earning in your other loans? Also, are you able to deduct loans that default from your taxes?

    I would like to start adding more money to my lending club portfolio but is seems like the taxes would be overwhelming as compared to just keeping my money invested in stocks.

    Josh

    • Unfortunately you cannot deduct the interest expense you are incurring for the money you borrowed, however you can net your losses from defaults against your gains to reduce your overall tax liability.

      Derek

      • This is not taking defaults into consideration, but if instead of taking a $10,000 loan at 7.78% (with a monthly payment of $312.35) you instead did not take a loan and invested that $312.35 per month, at 15% interest you would have $14091.83 in 3 years.

        I think you are better off not taking a loan unless you can get a 0% rate from a credit card, especially since you will be taxed on income that is not really income (since you cannot deduct your loan interest).

        Josh


      • Josh,

        I’m not sure where you’ll find an investment with a 15% return right now that has a monthly cash return like this — please let me know if you have something in mind — I’d love to take a look!

        The difference between a 7.78 interest rate and a no interest credit card is only that your returns will be smaller and you are forced to take higher risk investments in order to get a return.

        One way to get around the tax liability is to take your investing capital and put it into a tax-deferred IRA, however the downside to that then is you’re effectively paying your 10k loan using post-taxed dollars and putting it into an IRA…. so there are definite possibilities to avoid paying tax, but in my mind free money is still free money – even if it is a bit less as a result of your tax payments.

        Derek


      • Sorry, that was my mistake using 15%. Using your projected return of 12.5%, you would end up with 13,558.66

        I still think you are better off going this route, although it sound like it you already took out the loan. I do hope it works out for you — best of luck!

        Josh


  3. Stronger backbone than I’ve got. Seems like a lot of work for $500 when you’re risking $10,000.

    I like the idea, but social lending is still too new for me to want to try it. A lot of trust to place in other people in this economy. You’ve got to be willing to lose ten grand — something I can’t comfortably do at this point.

    No Debt Plan

  4. I did the same thing on Prosper with $1500, lending mostly to AA, A, and B borrowers. None of them had any defaults in the previous 7 years, had reasonably low DTI ratios, and a whole other subset of screens for additional safety.

    2 years on I have 25% of my loans in default and have lost $186.

    I think the worst is over and while I may have one or two more defaults, the large part of my remaining 28 loans should keep producing. I think I will make a little money in the end, but nothing worth the time and effort you spend selecting loans, etc.

    Greenback Radar

    • I hear your pain which is why I would never recommend this to someone who cannot cover the loan if the world melts down and all loans cease paying.

      Ultimately its all about risk appetite — if you would feel uncomfortable putting your name on the line by doing this, then its probably not for you.

      Although the future is always uncertain, I will say that the last 2 years really skewed that default rate — economic conditions are not normally that horrendous, so while I don’t want to make light of your situation, I am of the mind that such drastic downturns in the economy will not happen on that scale in the next few years, so the risk of a 25% default rate in the future is slim. Not zero however. I could be entirely wrong. Again, it all comes down to risk appetite.

      Derek

      • Adding to the ‘unattractiveness’ of this social lending arbitrage is applying some false hopes to the 15% hoped for interest.

        To even try for the 15% return, you have to go for the LendingClub E,F,G category of borrowers – and those have default rates from 4% to 8%. Net return is no greater than 10%.
        Chart is available on their Statistics page:
        https://www.lendingclub.com/info/demand-and-credit-profile.action

        My 2cents on this also is these are loans over a 3year period. The site has barely been in business that long – bringing up significant issues on track record. And borrowers in the later portion – year 2, year 3 – could easily transform from to a lower credit profile or just lose interest in paying off completely. Most borrowers are already trying to dodge paying their legitimate creditors with ‘consolidation’ loans, so what’s to prevent them from dodging paying off to a fly-by night site.

        Mike N


  5. I just received credit card checks with a 18 month 5.99% rate. This would give you a bit more interest rate spread. You would need to get a little creative by borrowing shorter than you are lending, which would add some more risk to the plan.

    The only way that you are going to get the 15% return that Josh is talking about is with some dividends. There are some good stocks with some higher dividend yeilds out there. Annaly (NLY) is a good example. The current yield is 16.80%. Another one to consider would be Frontier Communications (FTR) with a yeild of 11.5%. The big problem would be that you would not be able to cover the payments since you would have to sell stock to cover the payments. Also the a dip in the stock price would hurt if you had to sell at a bad time to cover your payments.

    Patrick

    • Patrick, don’t get fooled by those high dividend yields — the reason they look so appealing right is most likely because they are not sustainable.

      For example, Annaly (NLY) is in the business of mortgage-backed securities. I would not be very confident in their ability to continue to pay such a high dividend. Their decline in price reflects investors’ anticipation of a reduction in future dividends (and earnings).

      Josh

      • The good thing about NLY is that they are buying MBS backed by Fannie and Freddie. Default risk is not really the risk. The real risk that NLY faces is interest rate risk. A spike in interest rates would reduce the spread that they are able to generate by borrowing short and lending long. A big change in interest rates would drive the returns down considerably. The returns they are generating now are being driven by the fed holding interest rates low. As long as we are in this slow down and the fed continues to hold interest rates artificially low, NLY should be a good investment.

        That being said, there is no way I would borrow to invest long in this market.

        Patrick


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