Peer to peer lending works like matchmaking, where borrowers are matched with potential lenders who wish to lend for earning a good return. On these platforms, investors can put up money for lending and earn higher interest rates compared to a traditional savings account. But the borrowers pay less interest compared to what they would have to on a conventional bank loan. Peer to peer lending platforms makes money by charging a fee.
Before you get over-excited by the high-interest rates and invest money in peer to peer, try to understand that it is not like traditional savings. These may look like savings, but there is no safety guarantee. Peer to peer is investing, and you may end up losing your money.
Don’t be mistaken to think that since it’s online lending, it’s easier. On the contrary, the borrowers are cherry-picked by the platforms. There are in-depth credit checks in place to rate all the borrowers. A benefit of investing in peer to peer lending is that you don’t have to run for repayments. The platform does all the heavy lifting and chases borrowers on your behalf. Nonetheless, we can look past the risks that are involved in peer to peer lending.
New peer to peer lenders can only put 10% of their investable assets
The Financial Conduct Authority (FCA) has set strict rules for P2P lenders. The new investors cannot invest more than 10% of their investable assets (excluding personal residence) into peer to peer lending.
Is Peer to Peer lending risk-free?
No investment is risk-free. Let’s discuss the risks of p2p lending.
No Safety Guarantee
With traditional bank savings, the Financial Services Compensation Scheme (FSCS) provides protection. It pays for the first £85,000 of any money saved per person, per financial institution. Any funds you have invested in peer to peer lending doesn’t get this level of protection even though the lenders are FCA regulated.
Brexit Could Hit P2P Lending
While the EU and UK have agreed on a trade deal, we still are unaware of how much it will affect the economy. This is a big uncertainty. Most peer to peer lending platforms have not been through a substantial downturn, and it is unclear how they will.
The Risk of Not Getting Your Investment Back
The primary risk of lending is not getting back the money you have lent out. Every peer to peer firm has its own setup in place to lessen the risk of default. Before investing, make sure you know what type of provision funds have been put in place by your p2p provider.
The Advertised Rate is Not Guaranteed
Most lenders quote the ‘target’, ‘expected’ or ‘projected’ return for lenders, but the actual interest rate may be less. For instance, if part of the funds you lent hasn’t been repaid (and there is no provision fund) or if a borrower repays the loan early.
It may be difficult to withdraw funds early
The majority of peer to peer platforms allow you to take out your money early if you want by selling your existing loans to new lenders on the secondary market. This can work quickly, but it at times can take months to find new investors.
Funds may not get lent right away
You earn no interest when your cash is waiting to be lent out. Depending on the peer to peer lending platform, it can take several days to find borrowers. Remember this fact, especially if you are lending out a big amount.
Peer to Peer lending is a fast-changing industry. You must consider the unknown factors. There have been unfortunate stories about lenders in UK and US market collapsing. Things like this will happen, and there is no way of predicting them. All you can do is consider if you can take this risk or not.
If a P2P platform goes bankrupt, who would collect the loans?
Technically, p2p loans are between the borrower and you, so if the peer to peer lending platform went bankrupt, you would still be owed. Every p2p platform must have a ‘wind-down plan’. This means having insurance to pay for a third party to collect all outstanding loans. However, if this was to happen, things wouldn’t go as smoothly.
Risk Management for Peer to Peer Lending
The best way to mitigate risk is diversification. You can diversify your investments across:
- Several borrowers
- Different P2P firms
- Multiple investment types (real estate, equity, debt and p2p lending)
- Many currencies and countries
This helps lower the overall exposure and volatility of the loans. Other than diversifying your investments within peer to peer lending, your investment portfolio needs other types of investments as well. In fact, only part of your investment portfolio should be peer to peer lending unless you have high-risk tolerance and are an expert in investment.
The last tip for managing risk is underwriting. Underwriting is the process of credit approval. How does the firm decide whom to approve? What makes a borrower riskier compared to another? Investing in platforms that have a strict lending process. The firms underwriting should be based on:
- Credit score
- Identity and fraud checks of borrowers
That being said, even borrowers with good credit can sometimes fail to repay the loan. Both platform and investor can take measures to reduce the risk, but it can never be zero.
Protections and Guarantees
Peer to Peer lending firms works hard to keep your funds safe. There are two main risks, late payments and default. Most known firms have processes set up to recover debts when late payments kick in before growing to a default. Different platforms offer varying approaches to safeguard investors’ money. There are two common protections that most p2p platforms offer that make p2p lending safer.
A buyback guarantee is an agreement between the platform and the lender. According to the agreement, if a borrower makes a late payment or misses a payment for a specific number of days, the buyback guarantee kicks in. The firm buys back the loan from the investor. The loan is bought back either fully or partially. There is usually a difference in how many days of delayed payment is necessary for the guarantee to kick in. Most providers offer either 30, 60 or 90 days.
How much lenders are compensated varies from firm to firm. Some buyback guarantees compensate lenders for outstanding principal along with fully or partially earned interests and fees. Other buyback guarantees compensate investors for a specific percentage of the remaining principal, however not all of it. Platforms that offer these guarantees have their own terms and conditions, so make sure to read those before you invest.
Many traditional financial institutions like banks have a reserve of funds again the loan losses. There are peer to peer lending firms that also hold funds in reserve, called provision funds. The firms have to hold money that is to be distributed to lenders if there is a delay in repayment or if the borrowers default.
These funds cover a specific amount of loan principal, which is either lost due to default or delayed through arrears. This way, the lender gets the least affected. Like buyback guarantee, the degree of protection with provision funds is different for every platform.
When investing through peer to peer lending, you should know what these protections cost and when do they take effect. Make sure to understand the whole lending, funding and collection process.
So, is Peer to Peer Lending Safe?
We have discussed the three main areas of p2p lending including, the risks, countermeasures and guarantees. Therefore, we can say peer to peer lending is safe if you do your research and take all the essential precautions we have discussed.
There are several steps that you can take as a lender, and the platform has in place to increase the protection of returns. The bottom line is that you need to do your own preparation and planning before you lend money safely through peer to peer investing.