Peer to peer lending risks explained
While reading through various investing blogs and forums I noticed that a lot of people do not understand the risks involved in peer to peer lending. This is why I decided to write this article explaining what are actual risks and how realistic those risks are.
Peer to peer platform risks:
Each platform works a little bit different to stand out from others and each one brings their own risks that might not be applicable to other platforms.
For those that don’t know, buyback guarantee is when loan originator promises to buyback an issued loan if it defaults.
A lot of investors regard buyback guarantee as an ultimate safety tool. Allow me to shock your worlds, but it is not. In case a loan originator or a platform bankrupts, no one is buying back your loan. So please stop believing that as long as you have this feature, you are safe.
But loan originator bankruptcy is an extraordinary event. In normal conditions, the buyback guarantee is making your investments safer and reduces the risks of peer to peer lending. If possible it is always advised to use it.
Some platforms, like Mintos or Lenndy (different Lenndy, not the one that just closed), do not offer their own loans, but rather work as a mediator between loan originators and investors. The process is simple, loan originators offer existing loans, peer to peer platforms offer investors to fund those loans, and investors choose if they should invest or not. Such a structure allows platforms to grow rapidly but introduces new risks to the investors.
First of all, loan originators might bankrupt, so any buyback guarantees or loan repayments are called into question. I already explained the risks with buyback guarantees, so let’s talk about loan repayments.
If loan originator bankrupts, it is unclear what happens with his loan portfolio. Will another company buy a lot of cheap loans? Will another company continue to repay investors of those loans? Maybe those loans will just be forgotten as there won’t be anyone willing to pursue them? A lot of nobody knows in this situation. And it will vary case by case as every situation is different.
This is why it is important to understand the risks of investing in platforms with loan originators. They do create more risks but offer better diversification.
Platform bankruptcy is one of the most mentioned risks, but I don’t believe it is the biggest risk. Yes, platforms can go under and some already did. But most platforms have some sort of mechanisms set up, to protect investors in such cases. A most common setup is the following, in case of platform bankruptcy, a third party will take over loan management until all loans end. It will make sure all payments reach the appropriate investors and will try to get money from defaulted loans.
Of course with the third party, there are also some risks. Quite often it is unclear if this third party will take any fees from investors? What will it do with the money that was in the platform, but was not yet invested? And even who this third party will be? What happens if the third party also bankrupts?
To work around this risk, just remember that peer to peer lending is considered a risky investment and only invest money that you can afford to lose.
Cash drag happens when you do have money deposited into a peer to peer platform, but there are not enough loans that fit your criteria. This means that, even though you invested your money, it does not generate any returns. Cash drags can last a few days or for a few months, as an investor, you can’t predict cash drag length.
Few days long cash drag’s are common even on bigger platforms. Even on Mintos, the largest European p2p platform I am having a cash drag after I invested 700€ six days ago (186€ left as of writing this).
There are two reasons why cash drag is bad. First of all, you are not earning anything on the sum that you already deposited into the platform. If cash drag is long, it will be visible in your yearly returns. Secondly, you are holding cash in an most likely, an unsecured account. This means that you are not gaining anything more than keeping your money under the matress but are taking significantly more risks. Unless you like to live dangerously I would rather not do that.
I don’t think there is a way to fully avoid this risk, but there are few steps an investor could take to try to minimise it. As an investor, you should try to follow the market news, don’t deposit large sums at once.
This peer to peer lending risk is the most interesting in my opinion. First of all, let’s talk about loan quality. Every investor wants to invest in loans that will be paid in time. This is considered a good quality loan. Now as the peer to peer platform grows, it will attract more investors. Those new investors will fund more loans. There might be a situation, where investors are funding loans faster than the platform can offer them.
And thus begins the interesting part. As more an more loans get funded, more and more loans will be demanded. The platform managers can make a choice, let investors experience a cash drag if they can’t provide more loans, or introduce loans that before would have been denied. If they choose the latter, investors might be happy at first but might have a worse default rate latter on.
There isn’t another way to protect from it, other than monitoring the situation yourself. From time to time, look what kind of loans are offered, and think if you would like to invest in them. This risk is less problematic for manual investors, but harder to manage for auto investors.
Auto lending risks:
A lot of investors like to use autolend to invest in loans that fit their predefined criteria. It seems like a logical thing to do if you can have proper settings to manage it. Well sometimes autolend just sucks. It can bug out and don’t listen to your criteria. Or it can invest in loans that even though fit your criteria, are not something you would consider on your own. As a personal example, I can share my experience with Finbee platform.
Both loans are to the same company, both loans were according to my criteria. So naturally, auto lend-bot invested in both of them. That’s not something I would have done on my own. Cause when your goal is diversification, you don’t invest in the same company twice. And of course, autolend does not have a feature that would stop it in investing into the same company twice.
To avoid risks that come from using autolend, either stop using it or use it only on platforms that have a perfect record of it working as it should.
Market event risks:
Market changes are not dependant on the platform or the investor. Such risks and their management can only be reactive and not proactive.
When it comes to legal matters, peer to peer lending is quite a new sector. This means, that there are not a lot of regulations regarding investor protection or market control. Also, your platforms can be in different countries or even loan originators can be spread all over the world. There is a chance that in the future, new regulations will be introduced that will affect you as an investor. And you are not physically able to monitor legislation in multiple countries.
Of course, this risk applies to all types of investments, so just have this in mind. If you are investing in the US stock market only, then you would just need to follow the US and your country’s regulations. Same applies to peer to peer lending, but if you invest in platforms with loan originators, you might also need to follow more than two markets.
Some platforms allow investors to invest in currencies that are not the main currencies in the country where the loan is issued. For example, I can fund loans that are issued in Indonesia but fund them using Euros. This makes me and my investment vulnerable to currency fluctuations. What if Indonesian rupiah drops in value when compared to Euro? For the loan originator, it will be much harder to repay the loan. If the change in currency value is large enough and the loan originator is not careful enough, loan originator might go bankrupt himself, at that moment you can forget that someone will buy back that loan.
And loans can be issued 2-3 years into the future. Nobody can predict huge currency fluctuations that far away. Be careful when investing in markets that do not operate in your main currency.
Property price drop:
Peer to peer platforms that offer real estate development loans suffer from this risk. All of your loans are scheduled to end in the future, probably a year or two from now. When choosing those loans, one of the metrics that you looked for is LTV or loan to value. Well if something happens in the market, the value drops and suddenly you might find yourself with a loan that is bigger than the value of the project. And let’s not forget that LTV might be overestimated from the beginning.
In general, when it comes to real estate peer to peer lending risks there could be another article as long as this one.
General peer to peer lending risks:
General risks are what every investor into peer to peer lending will face. There is no way around them, so get used to them. You can try to minimise them, but you will still have to face them.
If you invest your loans, some will default. Get used to it. There is no way you can avoid it. So try to minimise the risks. Try to invest the least possible amount into one loan. If you have 1000€ spread it around as many loans as you can. This is why one of the criteria that I have for my self when choosing a peer to peer lending platform, look into what’s the lowest possible amount to invest. Basically, follow one rule, never put all of your eggs in one basket and you should be fine.
Borrowers leaving the country:
This risk is the extension of the defaulted loan risk mentioned above. Normally when a loan defaults, it either is repaid because of buyback guarantee or recovery procedures kick in. The recovery process will be different country by country and with each platform or loan originator. One big issue is the EU’s freedom of movement. It is significantly harder to recover the debt in the EU if the borrower leaves the country.
So there is a risk that borrowers will just leave the country and hide elsewhere, but realistically, this is not likely to happen. Simply because leaving a country just for a debt is a lot of work and also costs a lot of money. There is a chance borrowers will do it, but I wouldn’t be bothered by it too much.
This is another inherent risk of peer to peer lending. You are entering a contract that could last for a couple of years. Who knows what’s going to happen in the future. And yes, peer to peer lending is considered illiquid investment type. But there are workarounds to illiquidity.
First of all, most bigger platforms have a secondary market, that allows you to sell your loans to other investors. This allows you to leave earlier than planned but might come with a small platform fee.
But, also remember that if a crisis starts or some sort of unusual event happens where peer to peer investors want to leave the platform at the same time, there is a huge chance that secondary market will be illiquid. Everyone will want to go out, no one will want to go in. (On a side note, this could be an opportunity to buy a lot of cheap good loans)
It is new and unproven in crisis:
Yes, it is somewhat a new thing on the market, but some peer to peer platforms managed to outlive the 2008 crisis. For example, Zopa, a platform that existed even before the 2008 crisis managed to have positive returns even during 2008. But at the same time, they do agree that returns were lower than expected. You can read more about Zopa’s case in their own article.
To summarise peer to peer investment risks:
Peer to peer lending is a risky and relatively new type of investment. Like any other investment type, it has it own inherited risks and brings appropriate rewards. Before investing in this type of investment every investor should learn what he is risking and make his own judgement if he should do it.