Risks involved with P2P lending - Crowdinvestor.org

Risks involved with peer to peer lending

When you invest in P2P lending and Equity-based crowdfunding, it’s easy to focus on the returns offered the platforms. It is important to understand the risks involved as well. I will explain the risks and how you can mitigate them.

Peer to peer loans offers both secured and unsecured loans. Most of the loans in the industry are unsecured loans and secured loans are rare and are usually backed by luxury goods.

Although some platforms have 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.

I advise spreading your investment across a large number of borrowers, to ensure that the effects of one borrower defaulting on their loan is minimal on your overall investment. Just as it is recommended to invest in ETFs and index funds when investing in the regular stock market.

Credit risk

The risk of borrowers default on their loans. This can be due to unexpected circumstances, such as a loss of employment, external economic factors or ill health, or something more dishonest such as a deliberate attempt to defraud. Some platforms list a credit score and risk level for each project, demonstrating that the borrower can afford the payment of their loan.

credit score is a numerical expression based on a level analysis of a person’s credit files, to represent the creditworthiness of an individual. A credit score is primarily based on a credit report information typically sourced from credit bureaus.

Wikipedia

Cash drag

P2P platforms create a market of borrowers and lenders. If an imbalance exists of more borrowers than lenders, the lenders’ capital may sit idle waiting to be lent. This can significantly reduce returns.

Liquidity risk

Investors are contractually obliged to lend funds to borrowers over the term of the loan. The nature of lending is therefore illiquid unless the loan can be sold to a new investor. Depending on the platform it may be possible to trade loans on a secondary market. Generally, the larger the platform in terms of loan volumes, the more active or liquid the secondary market is. This makes it easier for investors to sell their loans and withdraw funds.

Project funding risk

The loan or project submitted by the borrower may not be fully or partially funded. Failing to collect the capital necessary, the project is canceled and the collected funds are returned to the lenders. In this case, the lender, who has recovered the funds, does not receive the full or partial expected profit.

The platform goes out of business

What happens if the platform goes out of business. Remember to check if the platform you are investing in, is regulated and have contingency arrangements to manage their loans in the event that they no longer exist. Crowdfunding and peer to peer lending needs tighter regulations in the EU and the rules differ depending on country and sites. In the case of bankruptcy, the risk of investment and interest loss remains.

The platforms in the UK, where P2P lending started out, are regulated by the Financial Conduct Authority. FCA dictates that P2P platforms need to have a sufficient plan in place to ensure borrower repayments continue, regardless of whether the platform is solvent or not. This protects investors to a certain extent.

Interest rates

With interest rates holding record-low levels since 2009, the P2P sector has largely grown in a low yield environment. The risk here is that P2P returns may not appear as attractive to investors, compared to other asset classes like equities in a higher rate environment.

Unemployment rates

If unemployment rates were to rise, the risk of borrower default would also rise, which in turn would lead to diminishing returns for the investor. During the recession of 2007-2008, the default rates of the British platform Zopa rose from 0.49% in 2007 to 5.07% in 2008.

It is well-documented that Zopa performed well through this period, with the platform printing returns of more than 5% in the entire period prior to 2014. In fact, post-2008, competition for borrowers was very low, which pushed up the weighted average borrower rates, providing investors with superior returns.

Property prices

If a loan backed by property moves into default, the platform 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? Secondly, what value will the property or asset be sold at? Typically, P2P platforms will ensure they have sufficient loan-to-value (LTV) ratios to make certain they can withstand a market downturn.

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Jacob
@Crowdinvestor. UX and graphics nerd, self-taught coder, certified geek.

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