Our social lending arbitrage expert, Derek, is back! After one of my Lending Club loans defaulted, I really wanted to know how Derek’s loans were doing! We’ll check in with him and see how his strategy is working…
Social Lending Arbitrage
Its been six months since I first introduced my Social Lending Arbitrage method to the mydollarplan community, and Madison has asked me to provide an update on where I stand with my method.
To summarize the idea, this method basically plays an arbitrage game similar to the no-interest credit card arbitrage popular on the site but with a slightly different twist in that I’m borrowing money at a lower interest rate and lending it out at a higher interest rate — and pocketing the difference.
Social Lending Arbitrage Numbers
I borrowed $10k from lenders at the Lending Club website at an interest rate of 7.78% and turned around and invested that capital (minus some service fees taken out by Lending Club as a part of the loan) to other borrowers with a higher risk profile than myself. It is a method wherein I profit off of varying appetites of risk. I have a higher risk appetite with this money than other lenders and as such, I make a return off borrowed money (Note that I have enough cash held in reserve from other sources that I am able to cover my loan should the social arbitrage world end tomorrow, so my sense of risk is appropriately higher than someone who does not have that).
Metrics as follows:
- Amount Borrowed: $10,000
- Interest Rate: 7.78% (Or $1,245 over 3 years)
- Total Fees: 1.25% (note that this has since gone up to 2.25%) (Or $125)
- Total Cost of Capital (3 yrs): $1,370 (13.70%)
- Amount Loaned: $9,875 ($10,000 minus $125)
- Loans filled ($25 per loan): 395
- Est. Default Rate: 2.5% ($247 in total)
- Net Invested: $9,628
- Average Annualized Return: 14.69%
- Service Charge: 1%
- Net Return: 13.69%
Total Return of Invested Capital (3 yrs): $2,166 (22.5%)
Arbitrage Gain (3 yrs): $797
Social Lending Details
I personally choose all 395 loans, which I feel was incredibly time-consuming, but also ended up being to my benefit, as the default rate is lower than normal (outlined in more detail below). I have not decided whether I would go that route should I do this again in the future, since it was more time-consuming than I was ok with.
The beauty of this system is that I have isolated all transactions related to this set up to one bank account which is fully automated — I don’t touch it month over month. My only real work after initial set up was to determine whether my default rate is staying below my forecasted rate of 2.5% (which I update quarterly).
I am 1 year into this plan and thus far, of the 395 loans I have funded, I have had 2 default (one with 3 payments made in total, the other with 6), which translates into a 1.50% default rate (assuming I will have another 2 default per year through the remaining 2 years). This equates into more of a return than I had originally forecasted. Happy day!
While it is next to impossible to determine which loans could potentially default in the future, I was highly surprised that of the sheer number of loans I have funded, 10 have had any late payments, and of those, only 2 have defaulted. My thought behind this is that barring unforeseen financial hardships that could occur to my borrowers, I would expect those that have been paying so far to continue to do so through the end of the loan term.
Selling Riskier Loans
I have kept a close eye on the credit scores on all my loans with a lower than B rating (the riskier loans in my portfolio) to see if they are getting “riskier” than they were when I originally funded the loan. Should any fall substantially far below their original rating (something at this point I consider subjective from both a rating perspective as well as my own viewpoint), I plan on selling the debt to someone with a higher risk appetite than myself.
How to do so? Luckily for me (and others), Lending Club and Prosper have provided their members the ability to sell the debt they own to other members on a trading website Folio Investing. This adds a degree of flexibility to lenders in case they want to pull out on one or many loans. It effectively provides me the ability to increase my liquidity should I need it (although there is the potential I would lose my return or even my principal should I have to firesale the debt). In my mind, the more options I have for worst-case scenarios, the better I can exit this position and minimize my losses should the worst happen.
Social Lending Projections
Using the updated default rate, my new forecast calls for me to earn approximately $835 over 3 years. This assumes I do not reinvest the return I make on new loans (which at this point I am not doing), so theoretically this return could be higher than that should I choose to do that (which I am considering, but have not had the time to properly research new loans). The idea that by reinvesting, I compound my return makes this plan all the more enticing! Not only am I receiving free money, I begin to see an even greater return as the free-money snowball gets larger over time.
I must reiterate that this investing method is definitely not for everyone. Every investment has a level of risk and while I feel this is easy enough for myself to earn a small return, others may not like the inherent risks of investing in a new vehicle such as social lending is. This is a relatively new type of investment and while the intent behind the system is very noble, some may consider the relative ease of borrowers’ ability to game the system to be riskier than worthwhile. Others may consider the return in actual dollars to be too small for some people to consider – this may be more work than worthwhile. Again, its a personal decision.
For myself, free money is free money, and is completely passive income, which in my mind makes the process worthwhile. What kind of free money returns do you have?
Lending Club is giving a sign up bonus to try out social lending for free. If you haven’t taken advantage of it yet, you can try it out at: Lending Club $25 Sign Up Bonus.