If you are looking for investment opportunities that are risk free, you might as well prepare yourself to be disappointed. There is no such thing as risk free investments, however great it sounds.
The fact that investing is not 100% safe should not discourage you from looking into different investment possibilities as long as you are fully aware of how the investment works in detail and what the specific risks are.
This article raises the question of how safe investing in P2P lending is. It will explain to you what risks are involved and, in this regard, what you can do as an investor to mitigate those risks. The article will also take you through examples of guarantees and securities that you might find in P2P lending.
Table of Contents
Is P2P Lending Safe?
First thing first:
Is peer-to-peer lending safe?
As established in the introduction, no investment type is safe as such, since investing and risk go hand in hand. Therefore, it goes without saying that investing in P2P lending through peer-to-peer platforms comes with a certain level of risk as well.
This article will dive into some of the risks involved in peer-to-peer lending, but before we get to that, we will have a look at some factors that make peer-to-peer investing lean more towards the unsafe side rather than the safe side.
Two reasons why P2P lending is less safe:
- Although most of the online platforms within the field of P2P lending are regulated, these regulations are provided by local authorities since there is no standard European regulation that covers investors widely (the European DGS does not cover money invested in loans). And since P2P lending has become such a cross-border industry, you would have to assume there is a potential risk of investing in a platform that is regulated by an authority different from your home country.
- One of the biggest competitive advantages these P2P lending platforms have is their level of transparency. This is great because it means that a lot of the sites provide investors with, among other things, helpful historical data about their loans and average returns. Unfortunately, you can still come across many platforms that are not being as transparent as they should, and it is not always easy for investors to tell who they are lending money to, for what purpose and at what rates.
All of that being said, the level of risk involved in P2P lending depends a lot on which platform you choose, and risks can be mitigated through safeguards such as buyback guarantees and other securities like provision funds.
We will of course go through ways of mitigating risks when investing in P2P lending, but not until we have had a closer look at the actual risks associated with this investment type.
Risks of Peer-to-Peer Lending
The risks of peer-to-peer lending can be divided into three risk groups:
- The risk of loan default and late debt repayments
- The risk of an unsuccessful loan originator going bust
- The risk of the P2P platform itself going bankrupt
In the following, the article will dive into the above mentioned three risk groups 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
Since P2P lending is a debt-based investment type where investors borrow money to individuals or businesses and gain returns from the interest rates, the biggest risk in peer-to-peer lending is this:
Borrowers to whom you have lent your money can make late repayments on the loan or the loan might even default completely.
This puts your investment at risk since the return of your investment depends fully on the repayments made by the borrower.
However, this risk is tightly connected to the specific platform that you invest through and their safeguard initiatives. For example, some platforms offer loans secured with underlying collaterals that investors will benefit from in case of late repayments or loan defaults while other platforms offer buyback and payment guarantees.
Thus, the consequences of a loan default or late repayment differ from platform to platform. Depending on how high your risk tolerance is, it is of utter importance that you investigate the various platforms and what approaches are put in place – if any – to mitigate and compensate for the risks related to P2P investing.
In the section further below about risk management and countermeasures of P2P lending, the article will explain what investors can do themselves to minimize the risks involved in investing in P2P lending through online platforms. Hereafter, we will look more into the specific approaches taken by these platforms such as buyback guarantees and provision funds.
2. The risk of an unsuccessful loan originator going bust
Some platforms only act as aggregators and make use of professional lending entities called loan originators instead of finding borrowers to their platform and offering loans themselves. This means that instead of lending money directly to 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 and the loan originators sell the loan to investors registered on the platform.
One of the advantages of this business model within peer-to-peer lending is, among other things, 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.
But the use of loan originators does bring an additional risk into play that would not have existed if the platform did not use loan originators.
What happens if a loan originator goes out of business?
Whether you are lending or borrowing money, you need to be able to trust that the entity you are working with will not be late on its settlement payments or suddenly go bankrupt. This is where a good P2P lending platform must really step up and perform an extensive due diligence consisting of, in particular, financial and legal analyses in the process of approving loan originators to their platforms as a way of minimizing the risk of initiating a collaboration with a loan provider that might end up going out of business due to, for instance, a lack of liquidity.
This risk of investing through a platform that uses loan originators can be mitigated by looking for platforms that apply something called skin in the game. Skin in the game is where loan originators keep a certain percentage of their own loans, normally between 5% and 15%. This means, in other words, that the loan providers themselves have something at stake and are more incentivized to take the credit approval seriously.
Worst case scenario if a loan originator goes bust:
Lenders might end up losing some or even all of 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 various 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 in the sense that they need to make more money than they spend and if they don’t, they will eventually go out of business. In other words, there is a risk that the peer-to-peer platform through which you are investing will go bankrupt.
In this case, the platform will be responsible for collecting the remaining debt from its borrowers and settling all outstanding investments. This, however, might take a good portion of time.
One way to reduce risks related to the bankruptcy of P2P platforms is to make a thorough audit of the specific platforms’ financial health (pro tip: stay away from platforms that do not publish their audited accounts) and read third party platform reviews before you start investing in P2P lending through any platform.
Risk Management And Countermeasures of P2P Lending
The best countermeasure you can take when it comes to managing the risks of peer-to-peer lending is diversifying your investments across multiple borrowers, loan originators and platforms. This helps to lower your overall volatility and exposure to loan defaults and bankrupts, whether it is the loan originator or platform.
Besides diversifying your investments within P2P lending among different borrowers, loan originators and platforms, your investment portfolio should contain other investment types than just P2P lending. In fact, only a small part of your portfolio should consist of P2P lending, unless you have a very high risk tolerance profile and are a real expert within the area of peer-to-peer lending.
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 securities related, it can become pretty ugly, if the loan provider goes bankrupt, and, as described in the section above, you might end up losing most if not all of your invested money.
The last risk management tip that we will go through here can be summarized as underwriting. What is meant by this is that you can lower your risk significantly by opting for P2P lending platforms that are strict with who they lend to. Platforms should preferably underwrite credit, affordability, identity, and 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. So even though the likelihood of a loan default or late debt repayments can be reduced, the risk can never be fully eliminated.
You can read more about the five main areas to consider when building a diversified peer-to-peer lending portfolio in this article.
Guarantees And Securities in Peer-to-Peer Lending
If a borrower delays a loan repayment, a proper P2P lending site would take the necessary steps to recover the debt as soon as possible in order to prevent the borrower from entering into loan default and protect investors’ (lenders’) money.
In this regard, peer-to-peer lending platforms and/or loan originators can offer different approaches to safeguarding investors’ money. In this paragraph, we will take a close look at two of the most common guarantees and securities in reducing the risk (not eliminating) of P2P lending and, hence, making it safer.
A buyback guarantee can be described as a binding agreement between the lender and the loan originator or platform. The agreement establishes that if a borrower is late with or misses a loan repayment for a certain number of days, either the loan originator or the platform (depending on the business model) is obligated to buy back the loan from the lender – hence the name buyback guarantee. The loan can be bought back either fully or partially.
A lot of loan originators offer their own type of buyback guarantee with different terms. It might for instance vary, how many days of payment delay is accepted, before a loan is repurchased, but usually it would be either 30, 60 or 90 days.
In addition, it might also vary 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.
Loan originators’ buyback guarantees become invalid if the loan originator goes bankrupt, and loans have to be handled somewhere else (in many cases, the loans simply get lost and investors lose their money).
You can read more about the different buyback guarantees in this article.
Another type of guarantee comes in the form of provision funds, also referred to as contingency funds. These funds consist of a tangible amount of either money or other kinds of highly liquid assets that are protected against the potential risk of bankruptcy and ready to be distributed to investors in case of delay or default.
The purpose of a provision fund – or contingency fund – is, in other words, to cover a certain amount of money that has been either delayed through arrears or lost because of loan default, thus ensuring that the lender is affected as little as possible.
As was the case with buyback guarantees, the extent to which you are secured by these provision funds depends on the loan originator or platform that offers it. Sometimes lenders are given the possibility of selecting their desired provision fund (for a fee) between a certain percentage range, e.g. from 0.50% to 35%.
You can find a list of buyback guarantees and provisions funds offered by peer-to-peer lending platforms here.
Summary: How Safe Is P2P Lending?
The article has now guided you through the risks, countermeasures and guarantees of P2P lending in order to elaborate a bit on the question:
Is peer-to-peer lending safe?
It was made clear from the beginning of this article that the simple answer to this question is:
No, peer-to-peer lending is not safe.
However, we have seen that a lot of different measures can be taken by investors and approaches can be implemented by platforms in order to increase exactly how safe this type of investment is. Therefore, the question to be answered at this point should not be focused on whether it is safe or not, but rather how safe P2P lending is.
In an attempt to convince investors that they will not lose money when investing in peer-to-peer lending, the platforms offer different types of guarantees and securities. These guarantees and securities 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 of their money.
Other ways of mitigating risks involved in P2P lending comes from the investors themselves and consists in, among other things, diversifying your investment portfolio and scrutinizing peer-to-peer platforms and loan originators before investing.
On P2PMarketData you can find data sharing p2p platforms that share data with the market and read thorough a great variety of P2P lending platforms reviews, all of which are written with the purpose of making the peer-to-peer market more transparent for you as an investor.