Is P2P Lending Safe? Peer-to-Peer Lending as an Investment

March 9th, 2021
13 minutes read

Like all investments, p2p lending carries some risk. And with that risk, a certain potential expected return. Every investment is somewhere on the risk/return scale. Stock market returns are potentially higher but carry greater risk. Bond returns are lower but should carry lesser risk to reflect that. Government bonds are supposedly the only risk-free investment due to their ability to collect money through taxes. And their interest rates are low. Really low, like below the rate of inflation low or in some European countries interest rates are even negative.

And you can’t make money from negative interest rates. But we can make money with p2p lending if we understand how it works, what it does, where the risks are, and how to manage them. So that’s what we will look at in this article.

Is Peer-to-Peer Lending Safe?

First, we answer the fundamental question.

Is peer-to-peer lending safe?

Just because p2p lending isn’t risk-free doesn’t mean it’s unsafe. In fact, we think understanding the risks gives you an advantage. You will be able to earn returns that are greater than the risk you take when funding part of a loan.

And that’s what p2p lending as an investment is. It’s a crowdfunded loan, and you are investing in a part of that loan to earn interest on your money.

To understand our risks, we need to understand what the marketplace offers and where borrowers or platforms can make their loans less or more risky.

Here are two scenarios where P2P lending could be riskier:

  1. Cross border regulation. Most of the online platforms in P2P lending are regulated. Yet, these regulations are local to each country since there is no standard European regulation that covers investors. The European DGS does not cover money invested in loans. P2P lending has become popular in many countries, and it’s easy to lend across borders. Understanding that your borrowers may be in a different country, you would have to assume that there is a potential risk of investing in a platform regulated by an authority different from your home country.
  2. When a lending platform isn’t transparent. One of the most significant advantages P2P lending platforms have over other investment types is their level of transparency. Investors benefit with helpful historical data about their loans and average returns. This transparency also can include collections rates to see how good their underwriting, collection rates, and default rates are. Unfortunately, you can still come across many platforms that are not being as transparent as they should be. It is not always easy for investors to tell who they are lending money to, for what purpose and at what rates. You should avoid these platforms since good quality loans on transparent platforms are widely available.

These two scenarios shouldn’t scare you. The level of risk involved in P2P lending depends most on which platform you choose. The lack of transparency issue you can avoid entirely by not investing on platforms with poor reporting. You can mitigate regulatory and other risks through safeguards such as buyback guarantees and other protections like provision funds.

Now we will look at the systemwide risks associated with this investment type. These are risks to understand regardless of which platforms you use your money to invest on.

Risks of Peer-to-Peer Lending

There are three basic risks in peer-to-peer lending:

  1. The risk of loan default and late debt repayments (Borrower risk)
  2. The risk of an unsuccessful loan originator going bust (Originator risk)
  3. The risk of the P2P platform itself going bankrupt (Platform risk)

We will look at these three risks and explain how they might occur and to what extent you, as an investor, will be affected.

1. The risk of loan default and late debt repayments

You know that P2P lending is a debt-based investment where investors lend money to individuals or businesses. You gain returns from the interest rates. That means the most significant risk in peer-to-peer lending is Borrower risk.

Borrower risk is the risk of the borrower defaulting on the loan, thus losing your investment and the potential interest you may have earned.

Image of a credit report from Experian

Here’s a sample credit report, which we won’t need to evaluate for our investment decisions.

Thankfully, we can manage this risk without needing to be a credit analyst ourselves. Most of this risk is tightly connected to the specific platform you choose for investment and how they safeguard your money. For example, some platforms offer loans secured with underlying collateral (like real estate). Investors can sell the collateral in case of late repayments or loan defaults, while other platforms offer buyback and payment guarantees.

This means the first step towards managing borrower risk, what happens when the borrower stops paying, differs from platform to platform. No matter the level of risk you are comfortable with, it is vital that you understand what platforms will do or won’t do to mitigate and compensate for the risks related to P2P investing.

We will look into more risk control measures that platforms use, like buyback guarantees and provision funds, a little later.

2. The risk of an unsuccessful loan originator going bust

Many EU-based platforms only act as aggregators and use professional lending entities called loan originators. The loan originators find borrowers to send to the p2p platform instead of platforms offering loans themselves. This means that instead of lending money directly on the platform, you are lending money to the loan originator, who will then pass on this money to the borrower. The same goes for the repayment of the debt, where the borrower will pay the loan originator, who again will pay the lender via the platform. 

In other words, with this business model, borrowing takes place outside of the peer-to-peer lending platform. The loan originators sell the loan to investors registered on the platform. You can see how Originator risk could affect you with the important role they play in the lending process. Using loan originators does bring an added risk into play that would not have existed if the platform did not use them. 

Overview of lending companies on Mintos example

A Company like Mintos lists and rates its loan originators

One of the advantages of this business model within peer-to-peer lending is that it enables the P2P platforms to focus entirely on administrative tasks and acquiring lenders (investors). This frees time to facilitate loans faster compared to a scenario where the platform itself would have to manage every part of the process.

What happens if a loan originator goes out of business?

Whether you are lending or borrowing money, you must be able to trust that the entity you are working with will not be late on its payments or suddenly go bankrupt. This is where you can separate good P2P lending platforms from bad higher-risk platforms. Good platforms must do extensive due diligence. The most important research you can do is learn the financial and legal analyses used in approving loan originators to their platforms as a way to minimize the risks. P2P platforms need to know if they are collaborating with a loan provider that might end up going out of business due to, for instance, a lack of liquidity.

You can mitigate the risk of a platform that uses loan originators. Look for platforms that make loan originators put some skin in the game. Loan originators need to have their own incentives to issue good loans matching our incentives as investors. Skin in the game is where loan originators keep a certain percentage of their own loans as an investment, normally between 5% and 15%. This means that the loan providers themselves have something at stake and are incentivized to take the credit process seriously.

What is the worst-case scenario if a loan originator goes bust:

Lenders might end up losing some or even all the money they had invested in the loan originator’s loan(s).

There are a few things you could do to mitigate the loan originator risk as described above. For example, you should make sure to diversify your investments across many loan originators. This will make you less vulnerable to a possible bankruptcy in one of the loan originators. We will take you through diversification as a risk management technique later on in this article.

3. The risk of the P2P platform itself going bankrupt

P2P lending platforms are normal businesses trying to make money. And sometimes they go out of business if they don’t earn enough. This risk is platform risk. It’s asking yourself the question: what’s the risk that the peer-to-peer platform itself will go bankrupt. 

In this case, the platform will be responsible for collecting the remaining debt from its borrowers and settling all outstanding investments. But this might take a long time. Some platforms use backup loan servicers. A loan servicer is a company that keeps the loan agreement in place for the borrower to pay back. They maintain accounts for payments and collections along with payouts to lenders in the event the platform itself cannot. And the platform cannot if they are out of business. The platform is the primary loan servicer, so this third-party company is known as a backup loan servicer. All mortgage companies have backup loan servicers, and p2p platforms in the US use a backup loan servicer like Vervent. After all, a platform failure should not mean that a borrower doesn’t have to fulfill their obligations and repay the loan.

Another way to reduce platform risk is to do a thorough audit of the specific platforms’ financial health (pro tip: stay away from platforms that do not publish their audited accounts). Read third-party platform reviews before you start investing in P2P lending through any platform.

Risk Management and Countermeasures in P2P Lending

The best thing you can do to manage the risks of peer-to-peer lending is diversification. You should be diversifying your investments across:

  1. Many borrowers
  2. Many loan originators
  3. Many platforms
  4. Many investment types (debt, equity, real estate, p2p lending)
  5. Many countries and currencies

This helps lower your overall volatility and exposure to loan defaults and bankruptcies, whether it is the borrower, loan originator or platform.

Besides diversifying your investments within P2P lending (numbers 1-3 above), your investment portfolio should contain other investment types too. In fact, only part of your portfolio should consist of P2P lending unless you have a very high-risk tolerance profile and are a real expert in finding good loans for investment.

If the P2P lending platform you are investing through is really an aggregator of loan originators, it is very important that you take a good look at the financials of each loan originator before you throw your money at them. Depending on the guarantees and/or protections offered, it can become pretty ugly if the loan provider goes bankrupt. Again, you could lose most if not all your invested money.

The last risk management tip that we will go through here can be summarized as underwriting. Underwriting is the credit approval process. How do they decide who to approve? What makes one borrower riskier than another?

You can lower your risk significantly by opting for P2P lending platforms that are strict with who they lend to. Platforms should underwrite based on:

  1. Credit
  2. Affordability
  3. Identity and
  4. Fraud checks of borrowers

before they are accepted to the platform. 

That said, even borrowers with great credit scores might end up in a situation where they are unable to repay their loans. Both we as investors and the platforms can greatly reduce the likelihood of a loan default or late debt repayments, but the risk will never be zero.

You can read more about the five main areas to consider when building a diversified peer-to-peer lending portfolio.

Guarantees and Protections in Peer-to-Peer Lending

P2P Lending platforms work hard to keep your money safe (at least most of them). When it comes to borrower risk, we have the two risks of late payments and non-payment. The best platforms have processes in place to recover debts as soon as late payments start but before growing to a full-on default.

Platforms and/or loan originators can offer different approaches to safeguarding investors’ money. Here we will take a close look at two of the most common guarantees and protections in reducing the risk of borrower defaults. These processes go a long way to making P2P lending safer.

Buyback Guarantee

A buyback guarantee is a binding agreement between the lender and the loan originator or platform. The agreement states that if a borrower is late or misses a loan repayment for a certain number of days, the guarantee kicks in. Either the loan originator or the platform (depending on the business model) must buy back the loan from the lender – hence the name buyback guarantee. The loan can be bought back either fully or partially.

Loan originators are motivated to offer a buyback guarantee since many loan originators want their loans funded by p2p lending platforms in the EU market. Terms do vary, but many originators DO offer buyback guarantees. One example of differences in terms could include how many days of payment delay is necessary before a loan is repurchased. Most offer either 30, 60 or 90 days.

Another difference in terms is how much lenders are compensated. Some types of buyback guarantees will make sure to compensate investors for the outstanding principal as well as partly or fully accrued interests and fees. Other types of buyback guarantee compensate lenders for a certain percentage of the remaining principal, but not all of it.

This buyback guarantee compensates lenders when the borrower defaults. HOWEVER, loan originators’ buyback guarantees become invalid if the loan originator goes bankrupt. Loans go to the backup servicer, or the loans simply get lost, and investors lose their money.

You can read more about the different buyback guarantees in this article.

Provision Fund

Many banks and conventional finance companies hold a reserve of cash to keep against loan losses. There are p2p lending platforms that hold cash in reserve too. In p2p lending, they are known as provision funds. Platforms have money ready to be distributed to investors in case of delay or default through a provision fund.

The funds cover a certain amount of loan principal that has been either delayed through arrears or lost because of loan default. This ensures that the lender is affected as little as possible.

Just like with buyback guarantees, there are varying degrees of protection with provision funds. It depends on what each platform or loan originator offers. Sometimes lenders have the possibility of selecting their desired provision fund (for a fee) between a certain percentage range, e.g., from 0.50% to 35%.

Know when these protections take effect and what they cost. You need to understand the entire lending, funding, and collections process in advance BEFORE you lend your money on a platform.

You can find a list of buyback guarantees and provision funds offered by peer-to-peer lending platforms here.

Summary: How Safe Is P2P Lending?

We look at the three main risks, countermeasures and guarantees of P2P lending so we can understand and answer the question:

Is peer-to-peer lending safe?

The answer is Yes, but only if you research and take the necessary precautions we’ve been talking about here.

There are many steps we can take as investors and that platforms can take to protect our returns and increase safety. We are trying to assess how safe P2P lending is and how do we make it safer? Your own preparation and planning before you invest will make your p2p investing safer. 

Platforms offer guarantees and protections to help investors feel more comfortable lending their money. These protections will serve as a kind of insurance for investors that will cover them in case of missing loan repayment or even a loan default and make sure they do not lose all their money.

Other ways of mitigating risks involved in P2P lending come from the investors themselves. These risk controls are the most important because any of us can do them, and it’s a mistake if we don’t. You need to diversify your investment portfolio and scrutinize peer-to-peer platforms and loan originators before investing. Only use those who are transparent and show concern for investor safety.

On P2PMarketData, you can find p2p platforms that share data with the market and read through many different P2P lending platforms reviews, all of which are written with the purpose of making the peer-to-peer market more transparent and safer for you as an investor.