Is P2P lending safe and what are the risks?
Is P2P lending safe and without any risks? No.
Anyone who’s looking for an investment opportunity that is completely risk-free is going to be disappointed. Legitimate risk-free investments simply don’t exist. So if you hear of a “risk-free” investment, it is probably best to avoid it.
Seasoned investors will quickly tell you that there is no legitimate investment opportunity that is 100% safe. This is not said to discourage you from investing, far from it.
Smart investment is possibly the only way to guarantee your financial security in the future. The best advice one can give you is to investigate several investment opportunities and fully understand how the investment works and the risks attached to it.
In this article, you can explore the risks of peer-to-peer lending and get some insight into some of the securities and guarantees offered by Peer-to-Peer lending sites to mitigate these risks. The purpose of this article is to help you get an understanding of how safe peer-to-peer lending is.
Risks of investing in Peer-to-Peer lending:
The main risks of investing in Peer-to-Peer lending are the following:
- The risk of late repayments and loan defaults
- The risk of the lending company going bankrupt
- The risk of the P2P lending platform going bankrupt
In the following part of this article, you can learn about each of these risks and how to make countermeasures against them.
1. The risk of late repayments and loan defaults
When considering P2P lending risks, it’s important to remember that the Peer-to-Peer lending business is an investment type based on lending money to businesses or individuals and gaining a return on this debt by charging interest. The single biggest P2P lending risk is your borrower either making late loan repayments or defaulting on his or her loan.
Obviously, your investment will be at risk in the event of late repayments or default, as your return completely depends on the borrower making their repayments. Thankfully, most crowdlending platforms are very aware of this risk and invest heavily in a series of safeguard initiatives. For example, some of the most reputable platforms only offer loans once the borrower can provide security in form of underlying collateral in case of loan default or late repayment. Other Peer-to-Peer lending platforms would offer payment guarantees and even a buyback guarantee.
2. The risk of the lending company going bankrupt
Many Peer-to-Peer lending platforms only act as loan aggregators and are backed by larger professional lending entities. They use the Peer-to-Peer lending platform to both offer loans and find borrowers. Under this business model, much of the borrowing takes place off the Peer-to-Peer lending platform and loan originators offer registered investors the opportunity to purchase these loans. If you are wondering how safe Peer-to-Peer lending is, considering this risk is important.
Working through this model offers a number of advantages to Peer-to-Peer lending companies. It dramatically reduces the risks of Peer-to-Peer lending to the platform as they are entirely focused on acquiring lenders and the administration of the tasks required. It frees the platform from having to manage every single aspect of the process. However, for investors, a loan originator is an additional risk that you need to be aware of.
3. The risk of the P2P lending platform going bankrupt
The easiest way to mitigate against the risks of Peer-to-Peer lending the only to work with platforms that have what’s described as interest. When the platform you’re working with has a vested interest in the loans, it approves this means that they have something to lose in the event lake loan repayments are defaults.
If the P2P lending platform you’re working with has a vested interest in keeping the risks of Peer-to-Peer lending profitable and easily managed. This type of platform offers a greater investment opportunity for the investor. After all, these lending platforms are businesses and they have a vested interest in not going bankrupt. It should be easy to identify a P2P lending company who are invested is in keeping its business afloat.
Risk management in P2P lending:
The best risk management strategy is to diversify your investments in different platforms, loan originators, and multiple borrowers. This will help lower your exposure to loan defaults and the overall volatility of your investment, whether you’re working with a P2P platform or loan originator.
Outside of diversifying your investment across different platforms and loan originators and among different borrowers, focus on ensuring your investment portfolio is spread across different investment types. Unless you have a high-risk tolerance, are you an expert in people ending, only risk a small part of your portfolio in this type of investment.
Diversification will help protect your investment from high-affected drops and wild fluctuations, especially in the sphere of P2P lending. Here are five proven methods you should consider when trying to build a diversified Peer-to-Peer lending portfolio.
1. Currencies
As the Peer-to-Peer lending market continued to grow in recent years, more and more currencies have become available for investment. As currencies can fluctuate differently, it’s important to consider having a diverse range of currencies in your P2P lending portfolio.
There are three major markets to consider: EUR, USD, and GBP.
It’s advisable to use your base currency as this is at the lowest risk from currency fluctuations and you also reduce your exposure to higher fees that are charged for crunchy exchanges.
2. Location
Why most platforms are based in Asia, Europe, the United Kingdom, and the United States there are Peer-to-Peer lending platforms available on all seven continents.
Depending on the country and continent you choose the risks can vary. For example, if the European economy goes into a slump, this may trigger a period of growth in the US and vice versa.
On the larger Peer-to-Peer lending platforms they will allow you to search by geographical location at my last count there are at least 20 different companies operating in over 45 different countries.
3. The type of platform
The lending opportunities offered by each Peer-to-Peer platform can vary depending on the platform. Depending on your risk appetite, the differences between business models of two crowdlending platforms can be very different. Some lending platforms operate using a business model that involves many parties in the lending process. By doing this they are managing the diversification and risk that they carry. Other platforms operate using three parties and these may be easier to understand as they are set up in a more Simplex manner. It’s advisable to do your research on the platform type you’re working with to understand the risks attached to either the platform or the borrower going bankrupt.
Borrower-Platform-Investor model (Three-party platforms)
These are by far the most simple type of crowdfunding platforms. Here it is often very simple to understand where the risks are, who gets to pay the fees on the platform, and more.
The structure of the investments in the process is more direct, making it easier for the person buying equity or lending money to clearly see and understand the process.
Borrower-Originator-Platform-Investor model (Four-party platforms)
Another business model that exists in the Peer-to-Peer lending sphere works with additional participant loan originators. The process is nearly identical, the only difference being that the marketing administration is split between two different companies. A loan originator and a P2P platform.
This system is far more complex and comes with additional risks, but it offers more options when looking to strategically diversify your portfolio. If you’re looking to manage your risks, you can diversify between four-party platforms and three-party platforms as each one offers different investment structures and guarantees to protect against loan defaults and other fluctuations that can affect your investment.
Examples of platforms that follow this model are PeerBerry, Mintos, Debitum, Lendermarket, TWINO, Swaper, and Bondster.
4. Loan types
Another key thing to consider when looking to diversify your Peer-to-Peer lending portfolio is the wide variety of loan types that are available. If you compare it with the bond market, for example, that only comprises states and larger enterprises.
Lending platforms offer you the opportunity to blend in a variety of different manners with individuals and companies. You can either fund the whole loan yourself or buy a fraction of a larger loan contract. All of which will help you reduce your exposure to risk.
The different loan types that are commonly available on P2P lending platforms:
- Consumer or pay-day loans
- Car loans
- Mortgage loans
- SME (Small or medium-sized enterprises) loans
- Real estate and Property loans
- Receivables and Invoice financing
5. Choosing the repayment method
Last but not least, the final way to diversify your Peer-to-Peer lending portfolio institute how and when the loan will be repaid. You can choose to get the total lump sum at the end of the loan’s term or you can accept payments in installments for the duration of the loan. How you structure the loan repayment method can help you diversify your portfolio and mitigate the risk of fluctuations in the market.
Annuities
Annuity loans provide you with equal installments that are repaid throughout the loan period. As the Peer-to-Peer loan is repaid, your loan repayments will increase while the interest repayments will decrease. This is attractive as it guarantees your continuous cash flow over the period of the loan. This loan type is popular for investors who have a more short-term strategy and a low-risk tolerance.
Serial loans
With serial loans, interest repayments remain the same throughout the loan period. With every repayment, the installment amounts and interest will decrease as the principle of the loan is repaid. This type of loan offers lenders more significant cash flow at the beginning of the loan. But this will gradually reduce throughout the term of the loan.
Bullet repayments
In contrast to the two methods listed above, a bullet loan is structured in a fashion that the loan does not become you until the end of the loan period. Once the loan reaches its maturity, they make a single large repayment to the lender. Because of how these loans are structured, the single repayment made when usually be higher as they charge larger interest rates. Bullet loans are popular in the Peer-to-Peer lending market and can be structured either as a full lump-sum payment or as an interest-only loan.
Guarantees and securities in P2P lending:
The best Peer-to-Peer lending sites operate in a fashion to prevent delays in loan repayments. They have measures in place to prevent borrowers from defaulting on loans to ensure they protect their investors. Here are two of the most commonly used methods to protect investor money and reduce the risks of Peer-to-Peer lending dramatically.
1. Buyback guarantee
This is a legally binding agreement between the platform our loan originator and the lender. Under the terms of this agreement, they state that should the borrower miss a loan repayment by a specific number of days are late with a specific payment, then the platform or the loan originator must purchase the loan from the lender. This is where the name buyback guarantee comes from depending on the terms and conditions of the agreement loans can either be bought back partially or fully.
While this may seem like a straightforward agreement, matters get complicated when you’re dealing with a variety of different loan originators and Peer-to-Peer lending platforms. The platform seems to operate its own style of buyback guarantee, all of which have different terms. For example, the number of days that a platform will accept before they must repurchase the loan was very great from as low as 30 to as high as 90 days.
Other Peer-to-Peer lending platforms will offer top levels of compensation to the lenders. The best platforms will offer a complete buyback with the outstanding principal and a percentage of any fees or interests that they’re owed. Other platforms will only buy back a smaller percentage of the remaining principal, but will not repay all of it.
Before committing to any investment in the Peer-to-Peer lending platform, understanding the terms and conditions of their buyback guarantee is important. It’s also vital to remember that it invalidates these buyback guarantees in the bankruptcy event of the loan originator and if they handle these loans outside of the P2P platform.
2. Provision Fund
Another popular form of guarantee is the provision fund; they sometimes refer to these as contingency funds. These are put in place by the Peer-to-Peer lending platform as protection to mitigate the potential risk of bankruptcy. This one’s container set amount of money or even highly liquid assets and women distributed to lenders with loan repayment delays or defaults.
The purpose of these contingency funds is only to cover a specific amount of money to cover any loss to investors because loan defaults are arrears. While in theory, provision funds are a great idea and are like buyback guarantees, the extent of security offered by these funds differs from platform to platform and from loan originator to loan originator. Most times lenders offer the opportunity to select the extent of the provision fund and it’s going to range from anything as low as 0.5% to 35%
Conclusion: How safe is P2P lending?
Now that you have a great understanding of the risk guarantees and countermeasures involved in Peer-to-Peer lending, it’s time to answer the initial question, How safe is Peer-to-Peer lending?
We made it clear at the start that like any investment answering this type of question is far from straightforward, As with any investment there are risks attached, never invest more than you can afford to lose.
There are a significant number of safety measures put in place by the Peer-to-Peer lending platforms to help mitigate against any potential loss with investing in Peer-to-Peer lending.
As with any investment, there is a risk attached, the easiest way to mitigate against this risk is to hold as diverse an investment portfolio as possible. While different parts of the market will fluctuate, it is rare that each will drop dramatically at the same time. Also, investment strategies should always have a long-term focus, this means you should leave your investments to grow for anything from 1 to 30 years depending on their nature. Long-term investment strategies statistically carry a lower risk than short-term (get rich quick) strategies.
The securities and guarantees put in place by loan originators and Peer-to-Peer lending platforms are quite convincing, and most times investors are happy they will not lose any money. They offer a level of insurance that helps investors in the event of loan defaults are late long repayments to prevent them from losing all of their money. As he mentioned previously, there are several ways that you can mitigate against losing money and Peer-to-Peer learning platforms. If you are careful in choosing the platform you want to work with and ensure that you diversify your investment portfolio significantly, then the possibility of you losing on these platforms is much lower.
We hope the information provided in this article will answer the question is P2P lending safe and help you understand the risks attached and how you can mitigate them. Remember that there are risks attached to all forms of investment, it is never a good idea to either borrow money to invest or as we mentioned previously invest more than you can comfortably afford to lose.