We are living in an age of abnormally low-interest rates and low inflation. That means that on the one hand there is a lot of demand for investments that offer good returns and on the other hand a lot of skepticism from people who don’t really know how these kinds of investments work.
A very common question I get is some kind of variation of this:
I am looking to diversify my investments and have been reading with interest your articles about peer to peer investments. From your experience, do you think these are safe platforms?
Let’s dig a little deeper into this question.
I like the first part as it means that the investor has already started investing in other asset classes, probably traditional ones like stocks and bonds. This brings us to the first point I want to make.
I don’t think P2P lending should be your first and only investment unless you have a very high-risk tolerance or really know what you are doing and have a specific strategy you are executing.
There are no get rich quick schemes in life, so if you’re thinking of going all-in with P2P lending due to the higher returns they offer, you should probably stop and re-evaluate. Investing and risk go hand in hand, and P2P lending is very clearly on the riskier side of the spectrum.
Moving on to the second part of the question, it’s fine to ask someone’s opinion on things, but I feel that there is no answer to this second part of the question. First of all, one investor’s experience does not prove anything. I might have had a great run with P2P lending but that doesn’t mean you will achieve the same results. Secondly, I always emphasize that you should not ask for investment and financial advice online.
A related question I get is the following:
Are P2P lending platforms regulated?
All the platforms I invest in and speak about on this blog are regulated (this isn’t wild west territory as in crypto), and one of the biggest selling points for these websites is how transparent they are. They are therefore incentivized to be transparent and show you historical data about their loan performances.
However, there is no standard European-wide regulation yet, so if you’re not comfortable with that, you might want to consider waiting until that’s implemented, although it could take several years for that to happen. If you don’t want to wait, you’ll have to assume the extra risk of some platforms being regulated by a different authority than your country’s own.
All platforms need to conduct KYC and AML checks and have other basics in place, but it should be very clear that they don’t offer any ultimate protection for your money in the way that banks can protect up to 100,000 euros of your savings. This is an investment and with any real investment, your money is always at risk.
What are the risks with P2P platforms?
Let’s move on to discuss specific risks when dealing with peer to peer lending platforms.
Credit Default risk
The repayment of your investment is directly dependant on the repayments of each particular borrower. In some cases, loans are secured with underlying collateral from the borrower, and in some cases not.
Loan originators sometimes offer buyback and payment guarantees making debt collection and repayment enforcement relatively easier. In other cases, loans are totally unsecured, and therefore carry a higher risk of repayment delay and borrower default.
Loan Originator risk
Ultimately, even with a payment guarantee and buyback guarantee in place, if the loan originator itself goes bust, you will most likely lose some or all of your money invested in its loans.
Many P2P platforms act as aggregators, bringing many loan originators on board and having them offer their loans to investors.
Each Loan Originator is a professional lending entity that is specialised in lending to a particular type of customer (consumer loans, businesses etc.) and is compliant with all relevant regulations in its respective country of operations.
Lending companies are founded with a purpose to generate profits. In case of unsuccessful business activities and failure to achieve the targets set, a Loan Originator can go out of business and stop operations.
A good P2P platform does some essential work here. Prior to partnering with a Loan originator, there should be an extensive due diligence process, consisting of financial, legal, and other analyses. Once the LO is approved, there should be ongoing monitoring of the Loan Originators’ performance.
Should a Loan Originator become late on any of its settlement payments, the platform typically initiates an in-depth investigation of the situation at the Loan originator including legal proceedings and on-demand site visits. If the Loan Originator ends up halting its activities, the P2P platform collaborates with the company and its appointed insolvency administrator in order to settle all outstanding investments in the particular Loan Originator’s listings on the marketplace.
The best way to reduce loan originator risk is to diversify among different loan originators and also to have a look at the financials of each loan originator to make sure they are sound.
This is the risk that the P2P platform itself will go bankrupt. There are many reasons why this could happen, but ultimately platforms are normal businesses that need to make more money than they spend in order to remain in business.
Some of them have startup funding but eventually, they will run out of their runway and need to find a way to stay sustainable. That is why I recommend that you check the audited accounts of platforms and only invest in those that are already turning a profit.
Platforms that don’t even publish their accounts are higher risk and I wouldn’t personally invest my money with them unless there is some very good reason to do so.
In the event that a platform goes out of business, the appointed insolvency administrator will be responsible to achieve successful settlement of all outstanding investments and partnerships. Good platforms also work with a Certified Auditor Office, providing a backup of all investment data for storage to the Auditor on a monthly basis. These should be some of the questions you ask about a platform before you decide to invest.
One way of reducing operational risk is to spread your investments across several platforms. But it’s not as simple as that, since more platforms = more work for you to administer everything and keep on top of what platforms are doing.
Most European P2p lending platforms operate in Euros, but some of them offer the opportunity to invest in loans denominated in other countries. Mintos is one such example. Fluctuations in the currencies can result in both higher losses and higher profits.
In order to diminish exposure to Currency risk, I make sure that any non-Euro investments I conduct have ample timeframes so as to be able to ride out any negative patches in the exchange rates. Thus, I will not find myself in a need to withdraw money to use for living expenses when the exchange rate is not to my benefit.
Focusing investments on only one asset class or investment type results in high exposure to the respective asset class or investment type. Therefore, even the smallest fluctuation can affect the return to a very large extent.
In order to diminish exposure to concentration risk, try diversifying your investment portfolio across several different asset classes, investment types and geographies. In my opinion, P2P lending should only compose a small part of your portfolio, unless you’re an expert in this area and have an appetite for risk.
Loans are very frequently delayed. There is a reason we are being paid high interest rates. And that reason is that the borrower, whether it’s a business or person, is in dire straits. That means that it is possible that they might not get out of their negative situation in time to be able to pay back their loans. In such cases, the loan is extended. Different platforms handle this in different manners, for example, Mintos have a buyback guarantee whereby any loans delayed by more than 60 days are automatically bought back by the loan originator.
However, if the loan originator experiences mass delays in payments from the borrowers, then it might be forced into insolvency, meaning that the loans are not only delayed but are most probably considered bad debt, and will never be recovered.
We are just going through the coronavirus pandemic and its negative effects on employment and businesses. This was a black swan event that nobody saw coming, and things like this can happen at any moment. You can read about my thoughts on coronavirus and its effects on P2P lending, but in terms of P2P lending risks, you just need to take into account that this is a potential risk.
There are several market risks that you can read up on, such as macroeconomic risks, political risks, legal risks, inflation risks, etc.
Many platforms, unfortunately, are not transparent with who they loan your money to and at what rates. We might not know if the money is being used for ethical business purposes or for some shady business. The platform might also be lending to borrowers at very high interest rates bordering on usury, while giving the investors relatively low returns.
For this reason, I recommend investing only in platforms that make transparency one of their core values.
What returns do I get for this extra risk?
I would be aiming for 8% to 14% per year as a target earnings rate before tax when investing in peer to peer lending sites.
Anything less than 8% and I would start to get worried and probably shift my investments elsewhere.
This is because peer to peer lending is not as safe as investing in real estate, just to mention another asset class, so if my returns get that low I would prefer obtaining more safety through real estate investments.
How can you minimize risks?
There are some things you can do on your end to minimize the risk of losing your money with P2P lending. Here are a few things I do.
Research and due diligence
You should always investigate each platform individually and you should also have a checklist that you use to evaluate in a uniform way. I’ve already shared some of the points I keep in mind when evaluating platforms.
You should always read reviews and investigate each platform yourself before deciding to invest. Ask other investors how they are doing, and have some interaction with the platform itself by chatting with them, phoning them or using their email support system. Check how they reply to you and use that to guide your investment decisions.
I have compiled a list of my favorite P2P lending platforms and also a list of peer to peer lending platforms that I don’t trust, and I suggest you avoid them as well. But always do your own research and don’t rely on my opinion or anyone else’s.
Diversifying your investments
Obviously, don’t invest all your money in peer to peer lending sites. It is never a good practice to put all your eggs in one basket. I like to keep a healthy balance of stocks, cash, investments in other businesses, real estate, and loans.
I recommend reviewing your investments on a monthly basis so that if you see a bad trend developing on any of the platforms, you can take corrective action early. It is also a good idea to diversify as much as possible. If you have €10,000 to invest, you can choose to put €100 in each loan, so even if 2 loans go bad, you will still have €9,800 safe.
You will still receive interest on all the other loans so by the end of the year you will still be comfortably ahead. In the game of peer to peer lending you must be prepared for a small percentage of loans to go bad, that’s just the nature of how things work. Don’t get too frustrated about it when it happens, but rather make sure that your overall returns for the year are positive.
As you can see there are several risks that need to be taken into consideration when it comes to P2P lending. At the end of the day, this is an alternative investment that is quite risky, especially since most of these European platforms are not very regulated and they haven’t been around for that long.
Whether you should go ahead and invest or not is a personal decision that takes into consideration things like your overall net worth size, your other investments, and your appetite for risk.
In my case, P2P lending fits in very nicely in my portfolio. I am happy to take the risk for the outsized returns, but it’s never going to be the biggest part of my portfolio either. I’d rather invest a bigger chunk in an active business that I can manage and influence or even the stock market which is well regulated and highly liquid.
What are your thoughts?