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Is Lending Club or Prosper a Risky Investment?
An article by Todd Tresidder of Financial Mentor mentions the “dangers” of peer-to-peer (P2P) investing. From my experience P2P investing is not risky, and I have evidence to prove it.
That’s not to say P2P investing is without its risks. It certainly does have risks. What Todd fails to mention is that all investments — including those that are traditionally called “risk-free investments” — have risks.
To put it simply, there’s no such thing as a risk-free investment. With any investment, you have to understand all of the risks and put them into the correct context.
Let’s discuss the context of these risks with P2P investing.
In reality, this type of debt investing has been around for many years. The problem is it was not available to the retail investor until recently.
I recently attended the peer-to-peer investment conference, LendIt, in NYC. It was very informative and featured some interesting developments in the P2P space.
It’s my belief we’re still in the early stages of P2P investing, and when I first started investing, it was retail investors only. According to Peter Renton of Lend Academy, only 15% attending were retail; the rest were institutional. This speaks volumes when professional investors get involved. But I digress…
Todd’s argument against P2P investing goes something like this:
Your investment profit is determined by mathematical expectancy [most simply understood as probability x payoff]. Expectancy = (Gain on a Winning Bet x Probability of Win) + (Loss on a Losing Bet x Probability of Loss)вЂ¦.
When filtered through that lens the problems with peer-to-peer lending are immediately obvious:
- Your gain is strictly limited to the interest rate, whereas your loss can be 100%, creating a negative risk/reward ratio.
- Your probability of gain or loss is impossible to define, because the system is too new to have been adequately stress tested.
The two primary issues in Todd’s article are default risk and interest rate risk.
Let me discuss the first point mentioned. This statement could be true of any fixed-income investment. So I’m not sure I fully understand why he might think this argument is exclusive to P2P investing.
In addition, if you invest in hundreds of notes, statistically speaking, I’m not sure how you could ever have 100% loss of your deposits. This would mean every single note invested would default.
More importantly, the second issue is true when directly referencing Lending Club’s and Prosper’s data, but there is much longer-documented history in which it’s exactly the same investment class as P2P investing. The comparison isn’t against high-yield bonds, either.
Both companies offer unsecured credit for up to five years. Lending Club’s and Prosper’s notes are almost exactly the same as revolving unsecured credit cards offered by commercial banks.
In fact, I invest only in borrowers who are consolidating or getting a better rate from credit cards. So we can agree a comparison to the default rates with credit cards would be a great judgment.
Fortunately, we have well-documented data available from the Federal Reserve for credit card default rates. The data from the Federal Reserve goes back to 1985.
We’ve experienced three recessions in that period. Readers will also agree during 2008 we experienced the worst recession since the Great Depression. Since 1985, the credit card default rate has averaged 4.7%. In the fourth quarter of 2020, the default rate peaked at 10.59%. In the recession before that, the default rate went as high as 7.79%.
So far, in my five-year anecdotal experience with Lending Club, my default rate is slightly over 3%. This is in line with the averages seen by the Federal Reserve for unsecured debt.
So based upon this data, it is more than possible to achieve positive returns with Lending Club and Prosper. Lending Club’s data during this period (Prosper had a different lending model at the time) also concurs with this statement. Collectively pooling all Lending Club notes during this period shows the returns were still positive. So if we experience another severe recession your returns should still be pretty decent.
Todd’s article doesn’t concur with my findings.
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Interest Rate Risk
The current gap between the 10-year Treasury note and credit card interest rates is huge — around 1,300 basis points (at the time of this article). P2P rates, while slightly lower than credit card rates, still boast an attractively high rate of return for an investor.
Even as interest rates eventually rise, investing in unsecured credit card debt will remain an attractive investment. Interest rate risk isn’t really a factor with P2P investing until we experience a much higher (say, 5% or higher) Federal Funds Rate.
P2P investing should remain an attractive investment for the foreseeable future, compared with other fixed-income investments.
From 1994 till now, the average interest rate has decreased only about 700 basis points. Credit card interest rates, even in this low rate environment, remain stubbornly high.
With the Dodd Frank regulations and an overall heavily regulated banking industry, the rates for credit card debt have barely budged during this low Federal Funds Rate period. With $850 billion in outstanding revolving debt, individuals still have a lot of debt to reduce and consolidate.
This means individuals are looking to refinance their higher interest rates to something lower. P2P companies Lending Club and Prosper are perfect candidates to take advantage of this gap, even if they get a small percentage of the total revolving debt.
All of this makes for a ripe time for the P2P investor to take advantage of the interest rate gap and help borrowers get a lower rate in the process, all the while generating a steady return on your P2P investment.
Is P2P Investing Risky?
All of these counterpoints do not completely eliminate the risks of investing in the P2P space.
For the retail investor this is really a new asset class, but it’s an asset class that’s been available to commercial banks for many years. Previously the only way a retail investor could buy in to this investment class was indirectly, through owning banking stocks.
P2P investing now bypasses the middleman.
Lastly, the only negative articles on P2P investing I see are from individuals with no direct investment experience. As someone who has over five years investing with Lending Club, I do have some insight into what works in the P2P investment space.
P2P investing isn’t perfect, nor is it without its risks, but it’s an investment that should be seriously considered. I’ll even make the bold statement that P2P investing is less risky than many other high-yield fixed-income investments.
For now I am investing in Lending Club and Prosper notes until other fixed-rate investments become more attractive.
At the current interest rates and with a commitment by the Federal Reserve to keep pumping liquidity into the marketplace, it might be many years before conditions change.
For high return, low risk and low duration investments, P2P is hard to beat at the moment.
P2P Risks: Professional analysis of the safety of peer-to-peer Lending
Risk vs. reward is a principal consideration for every investment decision, not only with P2P risks. However, with peer-to-peer lending (P2P) platforms advertising rates ranging from 3% to 19% the reward can be easily visualised. The challenge, however, relates to assessing the level of risk acceptable to the reward. The nature of lending money to individuals and/or businesses creates unique risks in comparison to traditional asset classes that investors should be aware of.
It’s worth noting that lending money through peer-to-peer lending platforms is an investment and for this reason funds are not covered by the Financial Services Compensation Scheme (FSCS). Ultimately, without FSCS coverage, investors’ capital and interest are at risk.
Risks can largely be categorised into: Performance Risk, Platform Risk, Market Risk, and Liquidity risk.
P2P Risks: Performance Risk
Although some P2P providers have put in place features to recover losses such as provision funds and asset security, there is a fundamental risk that a large number of borrowers default on their loans.
A further performance risk exists when an investor’s cash sits idle in their account waiting to be matched to borrowers.
Borrower default may result from a poor initial credit decision or economic factors (see market risk). Investors are advised to diversify across a large number of borrowers to ensure that the effects of one borrower defaulting are minimal on the overall investment. A large number of borrowers defaulting on their loan commitments remains a risk even after diversification.
P2P platforms create a marketplace of borrowers and lenders. Where an imbalance exists of more borrowers than lenders, investors’ capital may sit idle waiting to be lent. This can significantly reduce returns.
P2P Risks: Platform Risk
A number of risks exist at a platform level including insolvency, fraud and security. If a significant platform was to fail, found to be fraudulent, or if there was a significant cyber security breach, market sentiment would decline.
If a platform was to become insolvent the loan contracts between lenders and borrowers would still exist and contractually repayments should continue. FCA rules dictate that P2P platforms need to have a sufficient plan in place to ensure borrower repayments continue, independent of whether the platform is solvent or not. To a certain extent this does protect investors, however, if a P2P platform was to become insolvent this would create significant turbulence for investors and its possible losses would be incurred.
Platform fraud is a significant risk to the sector. Essentially, platforms must deliver on their promises. Nesta reported in the 2020 report ‘Pushing Boundaries’ the potential collapse of one or more of the well-known platforms due to malpractice was the biggest risk to the growth of the sector. In a bid to mitigate platform fraud the FCA stipulates that P2P platforms must hold client funds in a segregated client account, separated from their own operating cash.
Similar to fraud risk, 51% of P2P platforms surveyed by Nesta in 2020 regarded cyber security as a factor that could have a detrimental effect on the sector. Given that the entire P2P industry is based online, a severe cyber security breach is a real risk.
P2P Risks: Market Risk
Market risks relate to macro-economic factors that may affect the ability of a borrower to repay their loan or for the capital to be recovered post default. Similarly to fixed income investments, an interest rate risk also exists.
If interest rates were to rise, the interest rate paid by a borrower might not appear attractive in comparison to other forms of investments. For example, if Cash ISA rates were to rise to pre-recession levels of 5%, being locked in to a P2P agreement which pays between 5-6% may not be worth the risk.
With interest rates holding record-low levels since 2009, the P2P sector has largely grown in a low yield environment.
The question is clear: can P2P investing still deliver value in an environment of higher interest rates. Well, the good news is that if interest rates were to rise, borrower rates would also rise. In theory both the lender and borrower rate would rise.
Unemployment Rates – Consumer lending
In the consumer lending space, if unemployment rates were to rise, the risk of borrower default would also rise. It’s well documented that Zopa endured the 2007/2008 recession and during this period its default rate rose from 0.49% in 2007 to 5.10% in 2008. A rising default rate caused by unemployment would decrease investor returns and possibly lead to a loss of capital.
Property Prices – Property Lending
In 2020, 19% of the P2P sector related to some form of property lending. Whether borrowing for a property development, as bridging finance or for buy to let purposes, property generally secures the loan. If a loan moves into default the P2P provider has the ability to sell the property held as security. Two things are important here. Firstly, how easy will it be for the property to be sold and what value will the property or asset be sold at.
If property prices were to drop, the capital realised from the sale of the property price may be lower than expected. Typically, P2P platforms will not lend at 100% of the value of the property (LTV). Landbay for example will lend at a maximum LTV of 80% and an average of 68%. This should provide sufficient coverage providing the asset is correctly valued at the outset and the market does not drastically drop in value.
P2P Risks: Liquidity Risk
Investors are contractually obliged to lend funds to borrowers over the term of the loan. The inherent nature of lending is therefore illiquid unless the loan can be sold to a new investor. Depending on the P2P platform it may be possible to sell loan commitments on a secondary market. Generally, the larger the P2P platform in terms of loan volumes the more active or liquid the secondary market is. For example, there is currently high demand for loans on Zopa, RateSetter and Funding Circle, resulting in investors being able to sell their loan commitments and withdraw funds relatively quickly.
Investing in the peer-to-peer lending sector can deliver risk-adjusted, predictable returns, however there are unique risks that investors should be aware of. The illiquid nature of lending means investors should be prepared to commit for the term duration or be aware of the P2P platforms secondary market. Borrowers defaulting on their loans is an obvious risk that investors need to assess. However, further market and platform risks should also be evaluated when considering investing in the sector.
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Is P2P Lending a Good Investment?
Modified date: July 24, 2020
Table of Contents:
How P2P Investing Works
P2P platforms are called “peer to peer” because they bring regular people – peers – together to participate in two sides of the same transaction. While borrowers turn to P2P lending in order to apply for a loan, investors show up in order to secure higher than average returns on their investment capital.
Since there is generally no middle man involved in these transactions, fees are usually lower. Meanwhile, interest rates available to borrowers are often lower than rates offered by traditional banks as well. And to an even more extreme degree, the interest rates P2P investors earn on their money can be considerably higher than what they might earn by putting their money in a certificate of deposit or money market account.
For example, Lending Club’s advertised rates range from 6.95% all the way up to 35.89%. No matter who you bank with, this is dramatically higher than what you can get even on a long-term certificate of deposit.
This isn’t to say that banks are totally absent from the process. A P2P platform may use a bank as the servicing agent to administer each loan. But since the role of each bank is limited, the fees paid out to them only average around 1 percent per year.
If you choose to invest in a peer-to-peer lending platform, you will most likely invest in a series of “notes.” These notes represent small slivers of various loans, with some denominations as small as $25. Using this method, P2P lending sites allow you to spread a relatively small investment across many different loans. For example, a $10,000 investment can be spread across 400 notes of $25 each.
In order to become an investor on a P2P platform, you need to meet certain criteria. On some sites, you need to be an accredited investor, which means you must meet certain stiff income or net worth requirements. On others, you must meet your state requirements, which typically include earning a minimum income of $70,000 per year and/or having a minimum net worth of $250,000.
Popular P2P Investing Platforms
There are a growing number of P2P platforms that welcome investors. Three of the most popular include Lending Club, Prosper, and SoFi. All three are multibillion-dollar lending platforms, although each offers slightly different terms and requirements for investors.
In addition, some lenders in the P2P realm focus mainly on certain types of loans. For example, Lending Club and Prosper will make loans for just about any purpose, while SoFi favors student loan refinances and consolidations (although it offers personal loans as well). Other P2P lenders may focus on small business loans or almost any other niche you can imagine.
On most P2P platforms, loans are funded by both private individuals and institutional investors. Some P2P platforms will even allow you to a hold your investments in an individual retirement account (IRA). Meanwhile, it is possible to get double-digit returns on your money by investing in lower grade notes, which naturally carry a higher risk.
There is one very significant point to note before investing on any P2P platform – the loans that you are investing in are self-amortizing. That means that the value of your investment will gradually move towards zero as each payment is made.
Unlike CDs and bonds where you put up a fixed amount of money and collect your interest over the term of the security, P2P loans change in value over time. With P2P investments, you are investing in loans that are comprised of both principal and interest. In other words, you’ll earn most of your interest upfront, while receiving most of the principal back towards the end of the loan’s term.
For that reason, you must continually reinvest the payments that you receive into new notes. That will ensure that your money is fully invested, which will help you earn the rate of interest you expect.
Higher Rates of Return on Fixed Rate Investments
As noted earlier, you can easily earn double-digit interest rate returns on P2P investments – which is clearly the main attraction of P2P lending platforms. Generally, this is accomplished by including higher risk loans in your portfolio.
For example, Prosper grades it’s loans from “AA” (highest) to “HR” (lowest, or “higher risk”). AA loans pay an average of 5.48%, while HR loans pay an average of 10.78%. By investing primarily in HR loans, you can earn double-digit returns on your money.
…But With Higher Risk
There are four critical factors you need to understand when investing through P2P sites:
- P2P borrows can default, in which case you can lose money.
- The higher the rate of return on a loan, the greater the likelihood of default.
- There is no FDIC insurance coverage to protect your investment as would be the case if you held your money in a bank.
- The P2P site may require you to cover certain collection costs in the event that a loan goes into default.
Another factor to consider is that P2P platforms don’t underwrite loans according to strict bank standards. For example, SoFi will make a loan to a recent college graduate on the basis of a promise of employment, rather than an actual job.
If you are going to favor high risk/high return investments, you need to be aware of exactly what you are investing in. It is possible that because of loan default rates, your the higher returns could be cancelled out. It is also worth considering that P2P lending is a relatively recent phenomenon, and how the loans will perform in a recession is not entirely certain.
So Is P2P Investing a Good Idea?
Investing through a P2P platform can work well if you understand the risks you are taking. With that being said, the approach is to use P2P investments to supplement the fixed income portion of your investment portfolio.
Let’s say you are holding 30% of your portfolio in interest-bearing investments of varying maturities and earning around 3%. By investing 20% of your fixed income allocation in P2P loans that earn an average of 6%, you can increase the overall rate of return on your fixed income allocation from 3% to 3.6%.
Meanwhile, you should probably steer clear of investing all of your fixed income allocation into P2P loans. By doing so, you may be taking on an excessive level of risk. Lending Club recognizes this fact, and recommends that you limit your investment in their notes to not more than 10% of your net worth. That’s good advice.
Getting the Most Out of P2P Investing – For the Lowest Risk
Some strategies can help you reduce the risks involved in peer-to-peer investing. Here are some to consider:
- Diversify your holdings across many different notes, so that a default on any one of them will not be a disaster
- Favor loans with higher credit scores
- Favor loans with lower debt-to-income (DTI) ratios
- Favor debt consolidation loans over purchase money loans (loans that lower a borrower’s monthly payment are less risky than those that increase it)
- Favor loans where the borrower has greater employment stability
If you’re aware of the risks involved in P2P investing – and you know how to at least partially mitigate them – then P2P investments can be a welcome addition to your portfolio.
Do you invest in P2P loans? What has your experience been?
After lending several thousand dollars through the P2P site Prosper, I found that they have no way to declare a co-owner or beneficiary for my account. If I predecease my wife, Prosper will still merrily credit interest to my account and send 1099s to my (now inactive) Social Security number. My wife will have to file otherwise unnecessary tax returns for my estate, which will probably involve paying a CPA and possibly probate court to set up and administer.
Unless you have no inheritors or plan not die, you may want to add “can’t declare a beneficiary” to the risks involved with at least some P2P lenders.
This type of investment is not open to everyone. For example I live in Ohio. I had to search the fine print, but I did eventually find it on both Prosper and Lending Club. As a resident of Ohio I cannot invest directly with either.
I was an early Prosper lender. After five years I made zero profit. Considering TVM, it was a loser. It was an experiment I will never return to.
I have used Lending Club. Until recently, because I lived in Arizona, I could not fund new loans — I could only buy notes that were being sold on trading system. It was a real pain to look through all the notes and decide which to buy… think about investing $5,000 where you have to research each $20 increment you invest. Super time consuming. Then, if you want to sell notes, you have to think about how to price each one. I don’t think I lost money but I didn’t make much, especially for the work involved. I think you can now fund new loans being as an AZ resident (most other states already allow this I think). This makes it a little easier because you can just let lending club pick a basket of notes from various loans of different grades based on a risk level you select. However, you may still find you want to sell notes when people start missing payments. And you will have to buy new notes every so often or your account will just slowly turn to all cash, and Lending Club does not pay interest on money in your cash account. Also, if you want to “cash out” and invest in something else, you will have to sell all of your notes on the open market.. that can take some time and you may lose money if you have to sell your notes for less than face value… and you have to pay a 1% sellers fee. I decided it’s not worth the time to maybe make a couple of extra percent… Though I did not lose money, it is possible to do so. I had many notes that went bad…. It’s a part of the business.
Peer to peer investing is very tax inefficient. Interest earned is fully taxiable. Losses are capital losses and unless you have offsetting capital gains are limited to a $3,000 deduction.
Is P2P lending safe? How to lower the risks?
Regardless of the attractiveness of P2P lending, investors are becoming increasingly aware of the potential risks as well as the safety of P2P lending platforms. Is P2P lending safe? Is it a good investment opportunity?
The very short answer is: Yes!
– but you should get familiar with the potential risks when lending your hard-earned money on these platforms.
Let’s dive into it…
Table of contens
- Platform risk
- Credit risk and diversification
- Lack of protection scheme
- Statements from recommended platforms
- Technological risk
- Platform volume
- Regulation of P2P lending platforms
Risks associated with P2P lending
Risks associated with the P2P platforms can appear in different areas of the lending process. My answer to “is p2p lending safe?” starts with an understanding of the platform itself.
Platform risk can be considered in terms of the platform trustworthiness .
In a technological era, starting an online lending platform is actually a rather easy process. Thus, there is always the risk of someone exploiting this opportunity through malpractice.
Therefore always make sure that you lend your money through a platform with a proven track record.
For example, you can follow my investment portfolio and see my returns and experiences. I have invested in selected P2P lending platforms since 2020 and follow the p2p lending market closely.
Furthermore, you can also join some general discussions such as the facebook group P2P Investment Fellows . The question “Is peer to peer lending safe?” would be a great topic to discuss
Finally, also look into other investor experiences/reviews on Trustpilot and online forums such as P2P Independent Forum .
This will help you and give you an insight into the overall trustworthiness of the platform.
Credit risk and diversification
Credit risk is a risk present whenever one party lends money to another party.
This is the risk that the borrower will default and the investor (lender) will not get the money back.
If the borrower defaults on his loan, you stand to lose a big portion, if not all, of your money. However, this risk can be reduced…
One way to reduce the occurrence of this risk is to disburse your funds (diversify) to a larger number of borrowers.
You should lend smaller amounts to a larger number of borrowers. That’s what I do and it works great.
I only invest (lend) between 10 and 50 euros in each loan. Thereby, I have only a very small share of the loan and the credit risk is reduced.
You should also choose investment opportunities with buyback guarantees since most platforms offer this.
Then you are much more protected against any loss of the investment. I will uncover more buyback in the next section:
Lack of protection scheme
Lack of protection scheme is maybe one of the biggest risks associated with P2P lending.
It’s a bit like living without an emergency fund for unexpected and difficult times.
If you put your money as a deposit in a bank, in the case of bank failure, your money is guaranteed by the Deposit Guarantee Schemes. In general, this is not the case with P2P lending and you should be aware of that.
While many of the P2P lending platforms have set up some form of protection, such as buyback guarantees if the loan defaults, there are still platforms without adequate protection schemes for investors.
One of the biggest is Bondora and they do not offer buybacks. For that reason alone, I have chosen not to recommend that platform at all.
Personally, I only use and recommend p2p platforms with 100% buyback guarantees and in the unlikely case scenario that the platform goes bankrupt, the agreement still exists.
The buyback guarantee is just like an extra layer of security, where it’s very often the loan originator on the platform who will repay a loan to you after 60 days delay.
I think it’s really great, that most platforms offer this and it makes the investment less risky.
Also, you can look for platforms which have defined a plan with which they will be able to continue the process of collecting payments from borrowers even if the platform is going out of business.
Statements from recommended platforms
One of the platforms I personally use is called Fast Invest . They have stated that investors are secured through the loan agreement and will be paid back even if the platform stopped.
Another platform, actually the biggest peer to peer lending platform in Europe, is Mintos .
Martins Sulte from Mintos
I asked the CEO, Martins Sulte about this topic (is P2P lending safe?) and he answered:
“Investing always puts your capital at risk. This is true for all investments – not just Mintos. On Mintos, investors can find all the information about loans and lending companies that can help them make sound investing decisions.
We analyze the organizational and financial stability of the companies before they join the marketplace. We check their financial statements, underwriting policy, and risk management. Result of this process is Mintos Ratings, and these risk ratings of the lending companies are fully visible when investing in Mintos.
More than 95% of the loans on our marketplace come with a buyback guarantee. This means the lending company will buy back the loan and pay the interest if the loan is more than 60 days late.
We have hundreds of thousands of loans on our marketplace and this variety is a great opportunity for the portfolio diversification. Investors can buy small fractions of many loans, starting from 10 EUR. This allows investors to create a fully diversified portfolio, which helps the reduction of the risk and earns more stable returns.
Together, these factors are strong support for the Mintos investor protection.”
Alla Kisika from Grupeer
Co-Founder Alla Kisika from the Europea n platform Grupeer also answered the “is p2p lending safe?” question:
“When we talk about investing, it is very important to bear in mind that any investment is not 100% safe. Even if you invest in US government bonds or put your money on the deposit account with the biggest/safest bank, there are risks involved.
The investment yield, in fact, is the payment to an investor to compensate for such risk. Higher the risk, higher the yield in theory. In practice, there are some deviations from equilibrium, where the higher yield can be received for the not so high risk, or vice versa.
The European commercial banks, for example, offer negative interest rate at the moment. Whilst p2p lending platforms offer quite high investment return, whilst the risks are minimized.
The p2p lending platforms are a relatively new asset class, so to prove themselves, the p2p lending companies are trying to show to their clients that investing in business loans or funding the real estate development project is safe, by doing extra due diligence, monitoring or actively participating in the portfolio of its loans.
Besides that, the p2p lending company is actively working with the loan originators that are featured on the platform. This means that the partners are going through many financial and legal checks, have some stake in their own deals – “skin in the game”. The risk management varies from company to company, so it is important to choose a platform, which has a predefined scenario in case the defaults have happened.
At Grupeer all deals are secured with BuyBack guarantee- this is one of the keys conditions when we cooperate with loan originators.
Peer to peer lending can be safe when an investor chooses responsible peer to peer investment platform, which satisfies the criteria mentioned above. Also, don’t forget the golden rule of any investment – diversification.”
The statements are completely in harmony with my own view on p2p investing and how to secure your investment. Thumbs up
It should also be noted that there are steps taken by the regulatory bodies for the purpose of ensuring that all P2P platforms will have some form of protection scheme in the future. This is a great step that hopefully will take place in the near future and makes it safer.
Platforms are paying special attention to reduce and even eliminate (if possible) the technological or cybersecurity risk. Nevertheless, you should check the basic technology used by the platform.
Maybe you think how? Let me share a few tips
➀ Check if the website has a lock beside the website address in the browser:
This lock means the website has SSL protection and encrypts the link between a web server and a browser. In other words: That the site is trusted and secure. Just like this blog
➁ Check if they use Google two factor authentication or reCAPTCHA.
They work as an extra layer of protection and look like this:
When evaluating the platforms, make sure that they have enough demand and supply for funds (volume).
Here is an example of a positive development of loans funded at Mintos (January to September 2020):
If you invest your money in a platform with a low level of borrowers or low demand for funds, your money could be idle.
You want your money to work for you and be in an investment agreement rather than on an investment account.
Regulation of P2P lending platforms
P2P lending platforms have become a significant player in the financial markets.
As such, they could pose a risk for the markets as well as the economy if they are not regulated.
Currently, the regulation for P2P is less strict compared with the regulation set in place for other financial institutions such as banks.
Nevertheless, countries have started to create and implement adequate regulations which will control the activities of P2P platforms. These new regulations are increasing the protection level for investors, thus making the P2P lending safer.
Regulation in the UK
The regulatory authority responsible for P2P platforms in the UK is the Financial Conduct Authority (FCA). The FCA has the responsibility of evaluating each P2P platform and approve that they could conduct their activities. One goal of the FCA is to enhance the regulatory framework and define the action taken when a platform is faced with failure.
Regulation in Australia
P2P platforms in Australia are subject to the legislation set under Management Investment Scheme (MIS) framework. Consequently, because of the industry in which P2P platforms operate as well as the financial products and services they offer, under the Australian regulation, they should obtain two separate licenses. P2P platforms in Australia should have an Australian Financial Services License and Australian Credit License.
Regulation in the United States
In the United States, the regulation is defined from an investors side of the transaction and the borrowers’ side. More precisely, P2P lending platforms should adhere to regulations set by the Security and Exchange Commission (SEC) and legislation defined by the Consumer Financial Protection Bureau and the Federal Trade Commission.
Countries are moving in the right direction when it comes to the protection of your funds and the regulation of P2P lending activities and procedures.
The P2P lending market is in very positive development and will in time be very established as an investment opportunity like stocks and bonds.
Remember my friend that there is no such thing as an investment without risk
Nonetheless, there are investments in which you can invest your money and control most of the risks. One such an investment is to lend your money through P2P platforms. I really like this investment opportunity.
This type of investing is safe because the regulation for crowdfunding platforms is updated and implemented on a regular basis.
In addition, an effort from your behalf could increase the safety of these investments as long as you are not becoming greedy. Thus, it can be concluded that improvements in regulation and smart lending are making P2P lending platforms safe.
I hope you enjoyed this great article about “is p2p lending safe?”. Lending money through P2P lending platforms can be a rather profitable venture if you do it in the right way
The Pros and Cons of Investing in Peer-to-Peer Loans
More and more investors are turning to peer-to-peer lending as an investment option to complement the more traditional instruments they have grown accustomed to. As the younger investors enter the market, they naturally gravitate to options that somehow rely on modern technology for their processes.
Peer-to-peer (P2P) lending was born out of a need to provide borrowers access to funds without using a traditional bank or credit union but just through an internet platform.
P2P is a win-win solution for borrowers and investors. Borrowers try to avoid bank loans or in many cases aren’t applicable for a loan and have found peer-to-peer lending as a more convenient avenue to avail of loans. Investors have discovered that peer-to-peer lending is a great way to diversify their portfolio and yet get a respectable return for their investments.
Technically, the P2P “lender” is not the actual entity that lends the money but rather an intermediary that facilitates the lending process through its platform. These applications are now widely popular in the United States, UK, Australia, and other progressive financial markets. The United States remains a leader in the volume of peer-to-peer lending and investing transactions.
What is P2P Lending?
With P2P loans, it is individuals and investors who lend the money unlike in traditional loans where banks and credit unions are the ones lending the money. Imagine this scene: you’re short of cash so you go to your friend to borrow money with the promise of paying it back after one month. P2P is almost like that except that the P2P platform expands the whole thing on an industrial scale by matching borrowers to lenders for their mutual benefit.
So, it’s basically a scenario where people with an extra money offer to lend them to those who are in urgent need of cash (businesses and individuals). A P2P service (which is usually an online platform) acts as the broker and facilitator so that the whole process becomes easy, safe, and convenient for both parties.
Lenders are usually savers or individual investors who want a decent return on their money and borrowers are individuals or businesses who need some cash for legitimate needs. The borrowers need to prove that they have the capacity to pay back the loan and interest at the agreed time.
How Does P2P Lending Works
You can find many P2P platforms online but although they offer basically the same service, the process for each company may vary. Generally, it would follow these steps:
1. The borrower submits an application form to the P2P company for consideration and the platform starts the evaluation process;
2. The platform secures a credit report on the applicant and uses the information they get plus other data (e.g., loan characteristics) to assign a risk grade to the proposed loan with the corresponding interest rate. Note that the evaluation process differs from platform to platform;
3. If the company accepts the application, they will post a loan request on the platform’s website with details. Investors can then review all loan requests or narrow their search for specific loans that meet their preferences as to risk and return parameters;
4. In many cases, several investors will fund a single loan to give more investors the opportunity to diversify their portfolio and spread the default risk among multiple investors. If there are already enough investors who want to fund the loan, the platform coordinates with a bank (“originating bank”) that will originate the loan. These banks use the money they receive as deposits for this purpose, which the Federal Deposit Insurance Corporation (FDIC) insures;
5. The next step involves the originating bank to sell the notes related to the specific loan to the P2P platform. At almost the same time, the platform sells the notes to each lender who has committed to funding the loan according to the amount of the principal they have bound themselves to. Each note that comes from the platform is specific to each borrower, and the P2P company sometimes register the notes with the Securities and Exchange Commission (SEC);
6. These notes that the platform issues are also called “borrower payment dependent notes” pertaining to the underlying loan. Let us explain that investors can only receive their due payment if the underlying borrower repays his loan;
7. Normally, the P2P platform takes a fee on the loan including origination and servicing fees upfront. It then releases the remaining proceeds to the appropriate borrower.
The Advantages and Risks of Investing in Peer-to-Peer Loans
Due to its ground-breaking concept, P2P lending platforms have become popular, also because of the immense advantages they offer to both borrowers and investors.
Advantages For Investors:
While borrowers need the money and in spite of the risks, investors have some great advantages in p2p loans:
It’s no secret that nowadays if you keep your money in a savings account, you’ll commonly get no more than 1% per annum. If you want to earn a little more, you should prepare yourself to let your money stay for several months or years in an instrument (such as a Time Deposit). But with P2P, it’s possible for you to earn high single-digit returns for your money. If you are a risk-taker, it’s even possible to earn low double digits by funding borrowers who have less than ideal credit ratings.
And just think: if you invest a portion of your fixed income in P2P lending, you can increase the overall rate of return on that part of your portfolio.
You Can do Everything Online
What makes P2P lending distinctly different from other investments is that everything happens online. When we say everything, we mean the ‘paperwork’, investing, and receiving income payments.
You won’t have to brave the traffic to go to an office or dial a number to talk to an agent. You simply sign up on the P2P platform, transfer funds to the account, choose your investments and wait for your monthly payments.
When you invest in P2P, the platform will offer you “notes” – which are actually small slices of a whole loan. Of course, some sites would allow you to fund an entire loan. However, most P2P investors still prefer to invest in notes.
You can buy notes for as low as $25 each. So, if you invest $1,000, you can purchase shares in as many as 40 individual loans. If you invest $10,000, you can invest in as many as 400 notes or as many individual loans.
The great thing about it is that you can find some P2P platforms where you can assign the criteria for the loans that you want to fund. For example, you can just select higher grade loans that have a lower default risk and the platform will filter their offers based on that condition. Alternatively, you can go for higher interest rates but lower-grade loans and therefore much riskier.
Be warned: if you put your money on a certificate of deposit, you normally won’t receive any interest income until the certificate’s maturity date. If you go with a bond, you’ll get your interest quarterly or semiannually. That is not the case with P2P loans because you will receive payments every month.
Needless to say, it’s great if you want an investment that gives you a regular income.
However, there is one dimension of the monthly income situation that you have to keep in mind. The monthly payment that you will receive will include both interest and principal which means that the notes are self-liquidating.
Look at it this way: you have a portfolio of five-year notes and each month, you make the payments as your income. By the time the notes reach the end of their term, your investments would have amortized down to zero.
The thing about P2P lending platforms is that they minimize their costs by maximizing the use of technology. It is the same technology that allows these platforms to segment individual loans of individual borrowers into multiple notes that they can issue to multiple investors. There is also immense savings in overhead because P2P lending companies do not necessarily need to have a physical branch network but merely virtual offices.
However, the biggest cost eliminator for the whole system is the fact that they do not carry the loans on the books of the company nor the books of the originating bank. This conveniently exempts them from building up the corresponding funds to comply with bank capital requirements.
Risks Associated with P2P Lending
At first glance, the advantages of P2P lending for both borrowers and investors seem very striking but investors must also take into account several considerations. Looking at the risks from both investor’s and borrower’s point of view, there are more risks that fall on the side of the investor.
There are laws that seek to protect borrowers including usury laws, regulations against unfair collection practices, deceitful advertising, and discrimination. All of these still apply to P2P lending. Whether in P2P or another traditional lending, an investor will always have to deal with borrower credit risk, liquidity risk, interest rate risk, and regulatory risk. Here are some other points:
Your Money is Actually at Risk
Majority of investors in P2P lending may not be aware that the SEC does not cover the money they invest in the platform. So, if you’re really bent on putting your capital through a P2P platform, make sure you choose your platform very cautiously.
Look for one that is forthcoming about the risks involved and is transparent about their plans plus how they intend to cover your investment in case something goes wrong.
This is Still Technically a Young Industry
While lending is as probably one of the oldest industries in history, P2P lending is still a young industry. Its track record isn’t at all that deep because it traces its beginnings just during the time of the financial meltdown. Even if you put together the total experience to the top P2P platforms like Lending Club and Prosper, you still can’t get a convincing range of success record and experience.
This puts to question how investments in these lenders will perform in the coming years particularly when the next recession comes. Now that they have robust and maturing portfolios, we really can’t say for sure how they can adjust to the times. One thing is certain though: during a recession, the credit quality declines across all segments of the industry.
You are Funding Loans Without Any Security
Borrowers who take out loans from P2P platforms do not put up any security for their obligations. This means that if the borrower defaults, the lender holds no collateral that he can use to pay for the debt.
A borrower who defaults leaves the investors without any recourse – and the slimmest chance to get his money back.
You Pay Taxes on The Interest You Earn
The rule is: any interest you earn is taxable (except your Personal Savings Allowance). So, whatever interest you earn from your P2P investment, you have to declare on your annual tax return.
P2P Loan Borrowers Use it For Debt Consolidation
Debt consolidation is a band-aid solution for people with problems of multiple debts. Most P2P borrowers need money so they can apply this temporary relief for their present situation. Debt consolidation is far riskier than other types of loans because it’s merely replacing one debt with another. There is always the possibility of the borrower getting deeper into debt in the future.
In many cases, a borrower wants to consolidate his card debts into one loan. Once he gets the loan proceeds and brings back his card balance to zero, he might start running up balances on his credit cards again and increase his debts. As a lender, your risk exposure to this borrower increases.
There is No Secondary Market For Your Investments
Presently, some large P2P companies are doing something about the lack of a secondary market for P2P loans but don’t expect overnight results. This will be a slow and unpredictable process. So, if you buy a note for now, you should be ready to hold on to it until its maturity or it’s fully paid. Some notes will take up to five years which a long time for many investors. In case you need the cash out of your investment, you would find it almost impossible to find a buyer.
But do take note of this: in a secondary market, especially through a third-party contract provider, you would have to sell your notes at a significant discount so, you will receive a lot less for them.
Why aren’t P2P lending platforms concerned about the non-existence of a secondary market? Well, they immediately profit upon the origination and release of the loan so there’s no need to worry about defaults and long waits.
What About Investors?
Investors, on the other hand, must wait for the borrowers to make an actual payment on the underlying loans before they can receive payments from P2P platforms. On top of this, once the underlying loan defaults and the P2P company recovers some money from the borrower, they will charge a servicing fee before they pay the investors. This servicing fee goes to the collection agency that the P2P companies hire to run after the borrowers.
As the industry evolves, P2P lending platforms have been trying to lessen the credit risk. Some are now providing credit scores for every borrower, offering collection services for delinquent borrowers, and assisting in the diversification process through the sale of fractional loans.
Is Peer-To-Peer Lending Right For You?
The first thing you need to do is to determine your risk profile. Getting 8 percent to 10 percent annual returns sounds really cool but the risk of losing all your investment down the drain is a real possibility. The point is, do not invest in P2P if you will not be able to bear losing a large chunk of your principal.
Second, check if there are local restrictions on P2P. For example, the state of Ohio prohibits peer-to-peer lending altogether because they believe that the risk of loss and the possibility of fraud is bigger than any potential benefits it could give.
However, if you sincerely believe that P2P lending is the right one for you, then invest in a major peer-to-peer lender that has a track record and is transparent about its process. Think of names like Lending Club, Prosper, Funding Circle, Upstart, etc. – which share a registration with the U.S. Securities and Exchange Commission.
Also, they have sophisticated tools to evaluate every borrower according to their risk potentials so that, as an investor, you can get sufficient information before you choose which loans to fund. Also, this does not mean that your investment will flow without a hitch but these factors will help mitigate some of the risks of default.
And last, always go in the direction of diversification. If you’re putting money into P2P lending, then make sure you don’t put all of your money there. And be prudent – don’t lend $10,000 to a single borrower. Split your money into ten borrowers of $1,000 each so in case one or two turns out to be delinquent, you won’t get hit too hard.
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