A More Detailed Evaluation of the Borrow-To-Lend Investment Strategy, and When to do It.

I'm not a tax adviser or an investment adviser or any other kind of officialized expert on any of these topics. And I don't guarantee that the spreadsheet I offer on this page will work correctly. You have got to make your own choices and take your own risks. Good luck.

There is some discussion of this article happening here.

I got into peer-to-peer investing a few years ago starting at Prosper.com and then Lendingclub.com a year later. It's pretty common for investors who have good credit to realize they can borrow money at a low interest rate (like 7%) and then invest it at a higher rate of return (like 12%). Many borrowers on P2P lending sites are executing this strategy, for better or worse.

The borrow-to-lend strategy has been met with pretty damning opinions. And for good reason, there are a bunch of expensive issues that are easily overlooked and quickly sap the thin margin. Lenders often express skepticism toward borrowers who are engaged in this.

As I frequently do, I feel like there are a lot of valid opinions and valid points being made, but not much rigor. I also think it is perfectly obvious that this strategy MUST be a good idea some of the time. Just take an extreme example, it can't POSSIBLY be a bad idea in the case where I can borrow money at 3% interest and invest it at 30% with very low risk. That would be an obvious no-brainer. Even though it sounds unrealistic, very good borrow-to-lend-ish situations come up now and then. For example, my student loan rate is 5%, it doesn't make any sense for me to pay that back early if I can make a reliable 14% return elsewhere. That's practically the same thing as borrow-to-lend. In order to know when it's a good idea, you have to know how good your rates really need to be.

Here are two existing articles expressing reservations, and my responses. I have reduced the points they made into simplicity, but you can always read the detailed articles for yourself.

http://www.personalloanportfolio.com/15/borrowing-to-lend-earn-money-on-good-credit/

• There are costs associated with borrowing money.
• It's important to know this. But borrowing costs are 100% known before you even start, you can evaluate it perfectly.
• You won't make as much interest as you think you will.
• You might not. Yep, that's a thing that can happen. That's some good speculation, thanks. A different thing that can happen is that you DO earn enough interest. In order to decide what to do, you need to consider how much interest you need to earn, how much you are likely to earn, what risks you are taking, and how serious they are.
• Prosper is pretty much loaded with misinformation, foiling all your efforts, and borrowers will totally default and stuff.
• Um... okay, that's possible. The risk that your investment associates are scoundrels who are misleading you is always there. I have no idea what this point is doing in the article. You are no more or less likely to get screwed by Prosper or elsewhere just because you are using a borrow-to-lend strategy.

http://prosperlending.blogspot.com/2007/07/borrowing-money-to-lend-on-prosper-wise.html

• There are costs to borrowing.
• Known and predictable costs. Like I said above.
• The borrowed cash will be idle for some amount of time.
• This is a good point, people need to know this. Idle cash that is borrowed means that you are paying interest and earning none.
• Taxes on interest from your loan is not deductible.
• That would  be a HUGE problem, if it were true. (See below)
• Your earnings are taxed
• Yes. It's a significant cost and I explore it below, but it's not a problem you should fixate on. No matter how you invest, you are going to pay taxes, but you only pay a proportional tax on the earnings. I mean, you have to be making money to pay taxes, so don't sweat too much.
• You won't make as much interest as you think you will.
• Yeah, the other guy (above) said that too. You don't know that! You have to let people consider the merits and risks and make their own choices. They need tools, not declarations.
• You have to make money in the first year. (apparently)
• I found this glaring error in this article really annoying. For example, the author points out that you have to pay loan origination fees but makes the error of deducting the whole fee from the first year's earnings and never considering the second or third year of a 36 month loan, (which would then be fee-free). 
• Also, the author counts the cost of interest in the first year without acknowledging that the second and third year would have vanishing interest costs. This alone dramatically messes up the conclusions.

You CAN deduct interest you pay on the loan as an investment expense, everything you ever wanted to know about that is published in IRS Publication 550.

Okay then, time for more rigor! I set out to study this for myself and I'm a very math-y person, so I created a detailed spreadsheet to evaluate the expected outcome as I consider various scenarios. The results (for me) were not problematic, they were encouraging in fact. (You can download and try the spreadsheet with your own values). Let's talk about my results before we talk about yours:

Yep, in my particular case, using the most accurate data I have at this time, the most reasonable prediction is that borrow-to-lend will earn me $280k over the next 30 years (which is appropriate for my age). I'm not the typical person (and neither are you). Here's more about my scenario and what this is assuming and saying:

1. My credit will continue to carry a debt burden of $22400 at 6.78% APR in today's dollars. So every 6-12 months of making payments I should be able to access loans to bring my borrow-to-lend debt back up to $22400.
2. My ultimate rate of return for my intended investing continues to be 16.3%. (That's pretty high and probably won't stick, but it is my best objective prediction at this time.)
3. My tax rate on this income is 15%.
4. My loan terms are 36 months.
5. Inflation is 3%.
6. I can purchase notes at a rate of $10000 each month.
7. I follow this strategy for 30 years. (That's appropriate for my age)

Okay, before all the nay-saying, let's examine some disaster situations right away:

Extreme disasters!

• Oh no! I'm only getting a 12% return!
• I make $62k over 30 years. A little weak, maybe too risky, maybe I decide to stop it. I can do so without losing money.
• Oh no! I'm only getting an 8% return!
• I don't make money, but I don't lose money, I stop doing it and break even, I'm pretty comfortable with it.
• Oh no! My taxes are 25% and not 15%!
• I earn $176k over 30 years instead of $280k
• Oh no! My taxes are 75%! (I moved to France!)
• I STILL don't lose money. (That's the break-even for taxes. No problems there.)
• Oh no! Inflation is 6%!
• I earn about $151k over 30 years. (Actually, high inflation is subtly GOOD for borrow-to-lend. But you'd still be wealthier over a long time with low inflation, I can explain that some other time.)
•  Oh no! The best rate I can borrow at is 12%!
• Don't borrow it. (Duh!) (Even if I did, and everything else being equal I'd earn $50k, but it's too risky for me.)
• Oh no! I can't buy more than $2000 in notes each month! I have idle cash!
• Don't borrow so much money all at once. :)
• OR Lose money the 1st year while you get it invested, but still earn $222k over 30 years. (Lowest point is about $-500.00)
• Oh no! I started this and I have to get out after only 1 year!
• Make $1k anyway.

It's possible that a series of these events will end up causing me problems, but after checking it out and trying  different cases I found it to be unlikely, and I found it to be easily mitigated for my particular tolerance for risk. In fact it was WELL within my tolerance. And that is pretty much what investing is all about. This is clearly a good investment for me.

There's one more cost I left out of the discussion so far: Your time. You have to decide for yourself whether it is worth your time. For example, if I figured I'd only safely make $50k over 30 years... I wouldn't do it because $50k isn't much for 30 years and I don't think it's worth the distraction. But $280k is awesome. One way to look at that is it is 39% of what I would make if it were my own money (not borrowed), it's like getting a +39% bonus for spending a bit more time on something I'm going to be doing anyway and there doesn't appear to be much risk if something goes wrong. I'm already systematically managing my investments every day, after all. The fact that there's another $22400 bouncing around makes very little difference in effort to me.

I believe I've successfully shown that borrow-to-lend is a reasonable idea if you happen to have the right access to money and good investing behaviors. I also think this spreadsheet I made is a great resource you can use to evaluate some of your ideas. But don't just jump on the idea! The margins are slim, be smart about it and understand what you are risking in case things go wrong. I posted links to my spreadsheet so you can put your numbers into it and see what it has to say.