Investment arbitrage has been around for centuries and it has been applied to virtually every investment vehicle from the Dutch tulip mania of the 1600’s through to the complicated currency arbitrage of today. So, it is little wonder that a new investment vehicle such as peer to peer lending has also attracted those looking to use arbitrage in order to make money.
But first let’s explain what we mean by arbitrage. A simple definition is the simultaneous purchase and sale of an asset in order to profit from a difference in price. With social lending arbitrage someone takes out a loan from a social lending site, presumably at a low interest rate and then reinvests that money to earn a higher rate of interest. The borrower/investor gets to pocket the difference.
In the early days of Prosper some people were excited about the idea of social lending arbitrage but I haven’t heard of anyone who has made money successfully over the long term. But that hasn’t stopped people from trying. The personal finance blog, My Dollar Plan, is sharing the experience of one person’s social lending arbitrage experience. So far it has been successful but the strategy is still less than a year old. Here ia another example of someone who has recently taken the plunge into social lending arbitrage. I will be keeping an eye on both these examples and will report back on their success or lack thereof.
No Tax Advantages With Social Lending Arbitrage
One of the many disadvantages of social lending arbitrage is that taxes really eat into your return. Interest from loans on p2p lending sites is not deductible and you have to pay tax on all interest earned from your investments at your maximum rate. So unless you are in a very low tax bracket (in which case you probably should stick to safer investments) a substantial chunk of your earnings will be taken away in taxes.
Bottom Line: The Risk is Not Worth the Reward
Let’s take a detailed look at the example from Derek as laid out in My Dollar Plan. Derek has invested in 395 loans and he is expecting a $797 net return over three years, assuming a 2.5% default rate. I am assuming he spent some time researching these loans – let’s say conservatively five minutes per loan. Then let’s say he spends 15 minutes a week monitoring the account over the three years. That comes out to 72 hours work over three years for a $797 return, or around $11/hour. This doesn’t take into account the tax hit he will take, which will presumably reduce his return by 25% of more. I, for one, am looking for a better return on my time and passive investments.
The bottom line is social lending arbitrage is a risky strategy that doesn’t offer a great return. You are taking considerable risk by investing in high interest rate loans, and if default rates are higher than you expect you could find yourself with negative cash flow. I am all for keeping a portion of your portfolio for high risk investments, but borrowing money without the potential for a substantial return seems like a bad idea. While I don’t think social lending arbitrage will ever become a bubble like the tulip mania of the 1600’s, it is a high risk investment strategy. Even though I am a huge fan of p2p lending, I think it is best to do it with your own money.