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I noticed today that my bank is offering small loans of up to £15000 at 3.3% interest. Meanwhile, services like Zopa and RateSetter are offering over 6% interest on investments in their platforms.

I feel like there must be some catch here, but what is it? What's to stop me from taking out a loan from the bank, investing it at higher interest and pocketing the difference (presuming I am able to make the monthly loan repayments myself in the meantime)?

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    Clasic arbitrage scenario. I used to do Lending Tree, but it was not profitable enough to justify the time even with a cash investment. – Pete B. Jun 16 '16 at 18:34
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    @PeteB. (1) I wouldn't call this true arbitrage, as the levels of risk between the two loans may be significantly different; (2) Implying that the profit of such a plan would be higher with a cash investment is misleading; per-cost return to the individual is higher if they leverage the peer-to-peer loan with a personal bank loan. Instead, I think it would be more accurate to say that the risk decreases with a cash investment, but that the return on investment decreases as well. – Grade 'Eh' Bacon Jun 16 '16 at 18:57
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    Good luck getting 3,3% on successful application and that's it. The underwriter always suggests something in regions of 5-16%. I have never been able to get less than 5%. And that's pretty darn great put relatively. – Piotr Kula Jun 16 '16 at 22:35
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    The catch is that the guy offering you 6% didn't get a 3.3% loan at your bank, or else he wouldn't offer 6%. The bank obviously thinks he is too much of a risk, or that he already has enough loans with other banks (they can see the credit scores, you can't). – Alexander Jun 17 '16 at 8:29
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    Lots of large organizations did this prior to the global economic collapse. Then the companies they made the high interest loans to went out of business, and they still had to pay back the people they borrowed money from. There are pension plans that are short tens of millions of dollars because of this. – David Schwartz Jun 18 '16 at 1:02
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You must consider the different levels of risk associated with each loan.

When the bank loans you money, it does so based on a high degree of information about your financial situation (through your credit report + additional information gathered at the time of granting your request). It feels quite confident that you will repay them, and therefore considers you to be low risk. In order to make a profit off of all its low risk clients, the bank only needs to charge a small rate of interest - competitive with the market but enough to cover the losses from clients who will default.

When you loan money through a peer-to-peer program, you are at two distinct disadvantages from the bank:

(1) Your loan portfolio will not be diversified; that is, you may have only a single person or a small handful of people owing you money. Any catastrophic event in their lives may wipe out their loan to you. Whereas the bank can play the averages with a broader client base.

(2) You have less information, and ultimately less (effective) power to reclaim your losses. Would you feel confident walking behind the desk at a bank today, and deciding whether to approve someone's loan based on the information that the bank's back-end has already determined is necessary to make that decision? Now how about when you are doing it on your own?

Because of this, you take on more risk from a peer-to-peer loan than a bank takes on from you. That's why the person is willing (or, required due to market availability) to pay a higher rate; they know they are higher risk. That doesn't mean this is a bad idea, just that there is a specific reason that the difference in rates exists, and it implies that you should consider carefully whether the risks outweigh the benefits.

Note that the concept of taking a buy/sell position on two theoretically identical assets while earning a net profit at no risk is known as 'arbitrage'. Arbitrage situations rarely exist, and never for long. Whenever you see a position that appears to be arbitrage, consider what might make it not so. ie: you could buy inventory in location A, and sell it at 10% higher margin in location B - but have you considered transportation, carrying costs, and interest for the period that you physically held the inventory?

The appearance of arbitrage may (in my opinion) be a sign that you have incomplete information.

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    (1) isn't really a thing - you invest in 25 dollar increments, so while you're not as diversified as a bank, that's mainly because you have a lot less money than a bank has, to loan. (2) is absolutely a thing though. (Though one neat thing I did learn recently, that got me to try LendingClub with a little bit as an experiment: while defaults will mostly just be written off... you can, in turn, write off the losses on your own taxes to recoup those losses partially. :)) I wouldn't ever do LendingClub with money I didn't have, though, that's crazy risky. – neminem Jun 16 '16 at 20:52
  • @neminem I agree with you that I may have overstated the level of risk associated with having a few people on loan to (where having only $25 increments would mean you might have hundreds of people on loan to). However consider that $15k being invested in this way might represent a significant portion of someone's investment portfolio, and lacking diversification in other areas would cause a similar level of lopsided risk. eg: make sure you have other investments in addition these loan types, for overall diversification. – Grade 'Eh' Bacon Jun 17 '16 at 14:04
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If you think you can manage the risk and the spread is ultimately worth it to you, there's nothing stopping you.

I know in the U.S., in CA specifically, you need to have $85,000 annual income or net worth over some threshold to be able to loan more than $2,500 via peer-to-peer loan investing. I've had an account at prosper since around 2010, it does pretty well. It's made my taxes a bit more complicated each year, but it's been profitable for me. I wouldn't lever up on it though.

My Prosper Experience

My experience with Prosper has generally been positive. My real motivation for starting the account was generating a dataset that I could analyze, here's some of that analysis.

I started the account by trickling $100 /month in to buy four $25 loans. Any payments received from these loans were used to buy more $25 loans. I've kept my risk to an average of about A- (AA, A, B, C, D, E, HR are the grades); though the interest rates have reduced over time. At this point, I have a few hundred loans outstanding in various stages of completion. In calendar 2015 I had a monthly average of 0.75% of my loans charged-off and about 3% of loans at some stage of delinquency.

I receive about 5.5% of my principle value in receipts on average each month, including loan pay-offs and charge-offs. Interest and other non-principle payments comprise just shy of 20% of my monthly receipts. Prosper's 1% maintenance fee translates to about 8% of my monthly non-principle receipts. It's all a pretty fine line, it wouldn't take many defaults to turn my annual return negative; though in 5 years it hasn't happened yet. Considering only monthly charge-offs against monthly non-principle receipts I had two net negative months in 2015. I made about a net 4.5% annual return on my average monthly outstanding principle for calendar 2015. When I log in to my Prosper account it claims my return is closer to 7.5% (I'm not sure how that number is calculated).

The key is diversifying your risk just like a bank would. I don't know how the other services function at a nuts and bolts level. With prosper I choose which loans to fund which means I determine my risk level. I assume the other services function similarly.

Regarding collection of charged-off loans. I don't know how much real effort is expended by Prosper. I've had a few notes sold for about 10% of the outstanding balance; and I don't know who they were sold to. Comically, I have loan that's made more payments in collections than when it was in good standing.

There is definitely more to this than handing over $15,000 and receiving 6% on it.

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    If you write an article about your experience, I'd be interested in reading it. Lending Tree is supposedly better, and it was horrible. They basically did nothing to attempt to collect defaulting loans, and while I made money on my paying loans, the default rate was very high. – Pete B. Jun 16 '16 at 18:39
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    @PeteB. I expanded on my experience a bit. – quid Jun 16 '16 at 20:11
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    @Grade'Eh'Bacon I don't know the exact methodology of the grading system. But also included in each loan listing is some high level stats like current/open lines of credit, delinquencies in the last 7 years, stated income and FICO score range. My experience is only with prosper though not any of the other similar services. – quid Jun 16 '16 at 22:01
  • @Grade'Eh'Bacon I should also point out that I don't know if the grading methodology changes over time. Maybe an A today would have scored a B previously, or the opposite. – quid Jun 16 '16 at 22:11
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It depends solely on the risk your willing to take. For example, few years back one of the leading banks in my country was offering 25% interest rate for 5 year fixed deposits and the lending rate in the market was around 12%. So people borrowed money from other banks and invested in the high return fixed deposits. After 6 months the bank filed for bankruptcy and people lost their money. Later investigations revealed that abnormal high return was offered because the bank had a major liquidity problem. So all depends on the risk associated with return on your investment. Higher the risk, higher the return.

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