Blenders Borrowing-to-Lend: Earn money on good credit?

As I browsed Prosper loans, I was surprised at the number of community members who would like to use their good credit score to borrow money in order to reinvest the money in other P2P loans. This is called leverage and by definition it does increase risk. Is it a strategy that is likely to payoff?

The borrow-to-lend strategy was referenced before in an article on OmniNerd. As of this posting on the Prosper website, LeedsGirl (AA credit) is looking for $2,500 to reinvest in Prosper loans. Bpyatt is asking for a similar loan for $10,000 at 11%. MoneyDoc99 (AA credit) is borrowing money to reinvest as part of a Doctoral project. The list of people doing this goes on, and on and on. In fact, at least 5 of the 25 people who appeared on the first page of loans were lenders borrowing to reinvest in prosper loans. Another person on the front page is reinvesting in the Chinese stock market. The funniest part is the text of this loan request, which is already completely funded at 12%. Engle writes in his loan request:

I recommend this investment to anyone with $5,000 USD sitting around. The USD will continue to depreciate in the next few years… Since I do not have the capital to readily invest in foreign markets, I am request this loan to fund my “riskless” investment in the Chinese currency and market.

It sounds like he would also recommend this investment to anyone — even if they do not have $5,000 laying around to invest. I would certainly not call the investment without risk. If it was a “riskless” investment, it would pay the same rate of return as a US treasury bond. Maybe he forgot about the Asian financial crisis which occurred only about 10 years ago. I would question anyone’s investment acumen who calls an investment in single market on borrowed money “riskless.” Personally, I have been increasing my stock percentage in foreign funds due to the likelihood that the dollar will continue to depreciate, but it is certainly not a strategy without risk.

I am calling the strategy Borrow-t0-Lend, but many of the people on Prosper trying the strategy label the practice “Borrowing to Reinvest.” Other lenders call the people who borrow to lend “Blenders.” So is it a good idea to use your good credit score to lend to others with a lower credit score?

Take a $10,000 loan on Prosper and you will actually only receive $9,900 so you start out 1% behind. The interest rate at which people seem to be receiving these loans varies from about 8% to 11%, so I will use those sample interest rates as examples in my calculations for the ROI on this borrow to lend strategy.

Next, you must reinvest in various loans and earn a greater return on lenders with a lower credit score who require a higher interest rate to receive funding. For simplicity, I will use the highest sample number from Prosper’s own sample portfolio charts:

Prosper Sample Portfolios

I’ll give you the best case scenario, 11.5% RIO which had an initial stated interest rate of over 20%! I do not completely agree even with the 11.5% figure for reasons explained below. Let’s examine your profit for the three year period on borrowing from Prosper to reinvest in Prosper loans. Best case, you were able to borrow at 8%, but that cost you 1% of the loan value as a borrowing origination fee to Prosper, so you will likely earn the difference between 9% and 11.5% on $10,000. The most likely case (according to the data presented at Prosper) will earn you a return on investment of only 2.5% or $250.

If you must borrow at 11%, it is highly probable that you will lose money. By the numbers, you will lose 0.5% due to the origination fee on the borrowed money. A predicted loss of $50. A loss that also puts your good credit rating at risk.

I can hear the response from a few readers already: “But I am great at picking loans based on the information provided and don’t use the standard portfolio selection tool. Currently, I am earning X percent!” But what is your time worth? There is an opportunity cost to sorting through the loans on Prosper. Also, how long has the average loan been outstanding in that portfolio?

I fear that people are borrowing-to-lend based on too little data. Imagine the investor who has tried out a P2P lending network like Prosper for a year and had great success — maybe a 14% return with very few defaults. The lender might decide to take on the borrow-to-lend strategy to increase returns based on this data. However, that lender is still missing two years of data to determine the actual return on his investments. It is highly probable that other loans will default and there is always the possibility that economic conditions could change. Take the possibility that some of those borrowers will have an adjustable rate mortgage where the interest rate will reset causing foreclosure. By the time year three ends, the lender will not have a 14% return. Even Prosper’s own disclosure states (as also discussed on the Prosperous Land blog) that the default rate is based on a short time frame (only 16 months) considering that we are discussing three year loans (36 months):

Estimated average annualized loss rate based on the historical performance of Prosper loans for borrowers with similar characteristics, originated between Jun-01-2006 and Sep-30-2007, measured as of Oct-24-2007. Actual performance may differ from estimated performance due to many reasons, for example, worsening economic conditions.

Furthermore, both Fred and Lazy Man and Money pointed out that Prosper is occasionally posting misleading information (lazy man money link), so the data listed above, which is not rosy, may be whitewashed. Prosper also stated in a response to Fred that people have misrepresented their own rates.

This is making me wonder if Prosper is actually an efficient market? It seems players may be underestimating risks and basing decisions on too little data.

In my opinion, the borrow-to-lend strategy is not worth the risk to your personal credit score and is irrational market behavior. However, I doubt that Prosper will stop this strategy because they earn fees on both sides of the transaction with no risk since borrower and lender are assuming all credit, economic, and interest rate risk.

I expect someone to appear and comment who has tried the strategy and is doing great, but I want to talk to you about the final numbers at the end of three years of your borrow-to-lend strategy. With great probability, you will be sorry you tried it. Well, with the exception of the Doctoral student, the probable loss may have helped him earn a PhD.

Update: I ran across the borrowers who lend page and LendingStats.com. I drilled down on the person’s name and in many cases the estimated portfolio return was less than the person was paying in interest as a borrower. Of course that does not mean that all the people on this list were attempting to follow this strategy. Additionally, someone could have made a bad initial loan or two and have learned from mistakes. Those initial bad loans could be dragging down the portfolio returns.

Update2: Tom at Prosper Lending Review pointed me to his article on the same subject, borrowing to lend, that you may also interest you.

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