Borrowing money to lend on Prosper: Wise or Foolish?

Frequently you will see listings on Prosper where someone plans to take out a loan for the purpose of reinvesting the money back into Prosper at a higher interest rate. The idea is that you borrow money at a low interest rate and then reinvest it at a higher rate to make money on the carry, or price differential.

The concept is simple, and it is how banks earn much of their money. If they can pay less than 1% on money deposited in a checking account and then lend out the money at 8% then they are making money on the difference. This is also the idea behind the Yen carry trade, a popular investment technique where money is borrowed in Japan at very low interest rates and then reinvested in developing markets that have much higher interest rates. The risk, of course, is that currency fluctuations could wipe out any gains that you make.

At Prosper there is also a significant risk to this borrow-to-lend strategy. Before we look at the risk though, lets look at a wildly optimistic scenario:

Suppose you were a AA borrower with perfect credit. You take out a $10,000 loan at 8% (this is a below average interest rate for a AA loan of this size, but we are being optimistic). Then, lets assume you get really lucky and avoid defaults and late loans while lending at an average of 19% interest. Now you are probably thinking, wow I just made 11% on the carry. A cool $1100 of free money! Lets take a closer look to see if that is the case.

When you initially take out the loan you have to pay 1% in loan closing fees ($100 in this case). Then, if you are lending at 19%, you are in the B-HR credit grades on your loans so you will have to pay a 1% servicing fee on those loans (there goes another $100). Also, you have to wait for the money to transfer out and back in to Prosper. Then, once you bid on loans you have to wait for them to close. During this time, which will probably be about 30 days, you are not earning any interest on your money. That reduces the rate of return for the first year from 19% to 17.4% (11 months at 19% and one month at 0%).

So, instead of making 11% you are now at 7.4% in earned interest (we subtracted 1% for the loan closing fee, 1% for lender loan servicing fees, and 1.6% for idle money). Well, that's not too bad you think, it is still $740 in free money, right? Not so fast...

There is one more thing to consider: taxes. Prosper is not a tax friendly investment. Interest paid on money borrowed from Prosper is not tax deductible. To make things worse, money earned on Prosper is taxable as ordinary income. Lets assume you are in a 25% federal bracket and 7% state bracket. The federal government sees that you earned $1740 on Prosper (they are looking at just the lender side). In this case, your taxes eat up $556.80 of your earnings. Now you are down to $183.20 in first year earnings, and remember this is the optimistic scenario.

Now, lets look at a more likely scenario using the same methods and example as above. Only this time we will assume that you have a 12% default rate (this is a better than average default rate for loans at a 19% interest rate). Now, instead of earning money you post a loss of a few hundred to as much as $1000 in your first year of investing depending on when the defaults occur.

The worst case scenario is that you don't diversify, overweight in HR loans, or are particularly unlucky on your default rates. Under this scenario it would be easy to see losses well in excess of $1000 during your first year.

Looking at the numbers, the potential gain is small, and the risks are too great to make Prosper a viable place for making money on the spread in interest rates by borrowing to re-lend the money. It is possible to earn a reasonable rate of return at Prosper, but borrowing at 8% to re-lend makes it unlikely to be a successful investment.

What really makes me cringe is when I see postings from people with poor credit scores who are trying to borrow at 12% or 14% to re-invest the money back into Prosper. They are almost sure to lose money on their investment.

I have loaned money to one person who was trying the borrow-to-lend reinvestment strategy on Prosper. I loaned him money at 8%, which he reinvested in loans that have an average interest rate of 16.28%. He re-invested the full amount of the loan ($3000), and a nearly a year has passed since he made the investment. He now has 4 late loans, and according to LendingStats his estimated ROI adjusted for late loans will be 7.30%. That means he will be lucky if he breaks even on his investment.