Understanding the risks of peer-to-peer lending

Published by Danielle Levy on 24 October 2016.
Last updated on 22 August 2017

Rates on offer from deposit accounts continue to disappoint, pushing investors beyond the mainstream in search of a healthy yield.

Peer-to-peer (P2P) lending represents a growing market that has gained traction with investors as a result of the attractive returns on offer, typically between 5% and 7%.

P2P platforms create a market place for investors to lend money directly to individuals or borrowers. In return, they receive an attractive yield - provided the borrower does not default.

This nascent sector is not without its risks, however, so it is important to do your homework before you invest. In this article Moneywise outlines some of the key risks to consider.

No FSCS protection

Investing in peer-to-peer loans is not the same as putting your money in a savings account. There is no guarantee that the cash will be repaid and money lent through a P2P platform is not covered by the Financial Services Compensation Scheme (FSCS), which protects deposits up to £85,000.

The fact that you are putting your capital at risk is reflected in the higher interest rates that P2P loans offer, particularly in comparison to deposit accounts.

One of the biggest risks associated with P2P is that the borrower fails to repay the loan in full. The good news is that some P2P platforms have sought to mitigate the impact of defaults by creating provision funds that can be used to reimburse lenders, although in many cases this safeguard fund would not be big enough to cover a large number of defaults by borrowers.

Before you invest via a P2P platform, check whether it has a provision fund in place that can comfortably pay out lenders if defaults occur. The ‘coverage ratio’ can be used to measure this. This tells you the proportion of losses the platform would be able to cover.

Because of these risks P2P sits between savings and shares in terms of the risks and rewards on offer, according to Neil Faulkner, founder of P2P analyst 4th Way.

"P2P is a great middle ground between savings and the stock market. The risks associated with P2P are lower than the stock market and you can invest for shorter periods of time whilst earning higher interest than a savings account," he explained.

Although shares can be higher risk and more volatile, the returns on offer are potentially higher, so investors must work out what risk-reward balance they are comfortable with.

Access to cash

Trying to access your money once it is invested in P2P represents another challenge. The Financial Conduct Authority, the regulator, recently highlighted a ‘maturity mismatch’ as a key concern. For example, where investors make three to five-year loans yet the platform promises to return cash within 30 days if needed.

Cyrille Sallé de Chou, RateSetter’s chief risk officer, for example says: “RateSetter investors wishing to access their money early can 'Sell Out' of their loan contracts, as long as there are other funds in the market to replace the money being withdrawn early. 99.6% of 'Sell Out' requests are completed within one working day.”

But remember while this may be the case at present, it may not be as easy or quick to retrieve your cash and sell your loans in future. These difficulties could be amplified in the event of a financal crash or recession.

Laith Khalaf, senior analyst at Hargreaves Lansdown, says: “The peer-to-peer industry hasn’t been through a proper recession so it’s difficult to say how it would perform in these circumstances. There are a plethora of different business models at play in the peer-to-peer market so it’s important to do your homework on the precise risks associated with any particular offering.

“Generally speaking higher interest rates are provided to savers as a reward for taking on greater risk, and this is a good fact to keep in mind when perusing the products on offer.”

Understanding the platform

It is also important to understand the type of lending that is being undertaken. Are they personal or business loans? How much information do you have on the underlying borrower? Just because a provider offers lower returns does not mean that this investment is inherently safer than other loans.

Instead take a look at the platform's risk models and see what proportion of its customers have fallen into debt in the past.

Business loans are viewed as higher risk than personal loans because P2P companies can access more information on consumers via credit rating agencies. 

The next stage is to ascertain whether the loans are secured - and if so what against. If a loan is secured against property, look for a low loan-to-value ratio. If the loans are unsecured, make sure the platform focuses on higher quality borrowers. 

As with all financial transactions, be alert to the possibility of fraud. Read up on exactly what your cash will be invested in, and what checks your P2P firm puts in place on borrowers.

Angus Dent, chief executive officer of ArchOver, says: “Always look at the security provided and make sure it’s ‘real’. By real, I mean in terms of the asset being liquid, because without liquidity your cash cannot be returned, and real in that the security is recorded in a public registry.”

Given that many P2P platforms have not been through a full credit cycle, try to gauge the company’s track record to date, alongside the experience of the team. Make sure you fully understand any fees and charges, and how this will impact your return. Also consider investing using more than one platform, to spread your risk further.

Mr Khalaf adds: “Any loan is vulnerable to default and this applies to peer-to-peer loans, though this risk can be mitigated by investing in a pool of loans which is a common strategy.”

Five tips for successful P2P lending

By Neil Faulkner, founder of analyst 4th Way

  • Learn the basics of P2P lending before you invest any money.
  • Only lend when you feel confident that you understand enough about how the market works.
  • Set yourself strict criteria or rules before you start lending. For example, if you invest in loans secured against property, look for a maximum loan-to-value ratio. Alternatively, set yourself a minimum interest rate on prospective loans.
  • Always spread your risk across different P2P platforms.
  • Stick to the rules that you set yourself!

 

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