The Pros and Cons of Investing in Peer-to-Peer Loans


 

More and more investors are turning to peer-to-peer lending as an investment option to complement the more traditional instruments they have grown accustomed to.  As the younger investors enter the market, they naturally gravitate to options that somehow rely on modern technology for their processes.

Peer-to-peer (P2P) lending was born out of a need to provide borrowers access to funds without using a traditional bank or credit union but just through an internet platform.

P2P is a win-win solution for the borrowers and investors.  Borrowers try to avoid bank loans or in many cases aren’t applicable for a loam and have found peer-to-peer lending as a more convenient avenue to avail of loans.  Investors have discovered that peer-to-peer lending is a great way to diversify their portfolio and yet get a respectable return for their investments.

Technically, the P2P “lender” is not the actual entity that lends the money but rather an intermediary that facilitates the lending process through its platform.  These applications are now widely popular in the United States, UK, Australia, and other progressive financial markets.  The United States remain a leader in the volume of peer-to-peer lending and investing transactions.

What is P2P Lending?

With P2P loans, it is individuals and investors who lend the money unlike in traditional loans where banks and credit unions are the ones lending the money.  Imagine this scene:  you’re short of cash so you go to your friend to borrow money with the promise of paying it back after one month.  P2P is almost like that except that the P2P platform expands the whole thing on an industrial scale by matching borrowers to lenders for their mutual benefit.

So, it’s basically a scenario where people with extra money offer to lend them to those who are in urgent need of cash (businesses and individuals).  A P2P service (which is usually an online platform) acts as the broker and facilitator so that the whole process becomes easy, safe, and convenient for both parties.

Lenders are usually savers or individual investors who want a decent return on their money and borrowers are individuals or businesses who need some cash for legitimate needs.  The borrowers need to prove that they have the capacity to pay back the loan and interest at the agreed time.

How Does P2P Lending Works

You can find many P2P platforms online but although they offer basically the same service, the process for each company may vary.  Generally, it would follow these steps:

  • The borrower submits an application form to the P2P company for consideration and the platform starts the evaluation process;
  • The platform secures a credit report on the applicant and uses the information they get plus other data (e.g., loan characteristics) to assign a risk grade to the proposed loan with the corresponding interest rate. Note that the evaluation process differs from platform to platform;
  • If the company accepts the application, they will post a loan request on the platform’s website with details. Investors can then review all loan requests or narrow their search for specific loans that meet their preferences as to risk and return parameters;
  • In many cases, several investors will fund a single loan to give more investors the opportunity to diversify their portfolio and spread the default risk among multiple investors. If there are already enough investors who want to fund the loan, the platform coordinates with a bank (“originating bank”) that will originate the loan.  These banks use the money they receive as deposits for this purpose, which the Federal Deposit Insurance Corporation (FDIC) insures;
  • The next step involves the originating bank to sell the notes related to the specific loan to the P2P platform. At almost the same time, the platform sells the notes to each lender who has committed to fund the loan according to the amount of the principal they have bound themselves to.  Each note that comes from the platform is specific to each borrower, and the P2P company sometimes register the notes with the Securities and Exchange Commission (SEC);
  • These notes that the platform issues are also called “borrower payment dependent notes” pertaining to the underlying loan. Let us explain that investors can only receive their due payment if the underlying borrower repays his loan;
  • Normally, the P2P platform takes a fee on the loan including origination and servicing fees upfront. It then releases the remaining proceeds to the appropriate borrower.

The Advantages and Risks of Investing in Peer-to-Peer Loans

Due to its ground-breaking concept, P2P lending platforms have become popular, also because of the immense advantages they offer to both borrowers and investors.

Advantages For Investors:

While borrowers need money and in spite of the risks, investors have some great advantages in p2p loans:

Higher Rates 

It’s no secret that nowadays if you keep your money in a savings account, you’ll commonly get no more than 1% per annum.  If you want to earn a little more, you should prepare yourself to let your money stay for several months or years in an instrument (such as a Time Deposit).  But with P2P, it’s possible for you to earn high single-digit returns for your money.  If you are a risk taker, it’s even possible to earn low double digits by funding borrowers who have less than ideal credit ratings.

And just think:  if you invest a portion of your fixed income in P2P lending, you can increase the overall rate of return on that part of your portfolio.

You Can do Everything Online

What makes P2P lending distinctly different from other investments is that everything happens online. When we say everything, we mean the ‘paperwork’, investing, and receiving income payments.

You won’t have to brave the traffic to go to an office or dial a number to talk to an agent.  You simply sign up on the P2P platform, transfer funds to the account, choose your investments and wait for your monthly payments.

Diversification

When you invest in P2P, the platform will offer you “notes” – which are actually small slices of a whole loan.  Of course, some sites would allow you to fund an entire loan.  However, most P2P investors still prefer to invest in notes.

You can buy notes for as low as $25 each.  So, if you invest $1,000, you can purchase shares in as many as 40 individual loans.  If you invest $10,000, you can invest in as many as 400 notes or as many individual loans.

The great thing about it is that you can find some P2P platforms where you can assign the criteria for the loans that you want to fund.  For example, you can just select higher grade loans that have a lower default risk and the platform will filter their offers based on that condition.  Alternatively, you can go for higher interest rates but lower grade loans and therefore much riskier.

Passive Income

Be warned:  if you put your money on a certificate of deposit, you normally won’t receive any interest income until the certificate’s maturity date.  If you go with a bond, you’ll get your interest quarterly or semiannually.  That is not the case with P2P loans because you will receive payments every month.

Needless to say, it’s great if you want an investment that gives you a regular income.

However, there is one dimension of the monthly income situation that you have to keep in mind.  The monthly payment that you will receive will include both interest and principal which means that the notes are self-liquidating.

Look at it this way:  you have a portfolio of five-year notes and each month, you take the payments as your income. By the time the notes reach the end of their term, your investments would have amortized down to zero.

The thing about P2P lending platforms is that they minimize their costs by maximizing the use of technology.  It is the same technology that allows these platforms to segment individual loans of individual borrowers into multiple notes that they can issue to multiple investors.  There is also immense savings in overhead because P2P lending companies do not necessarily need to have a physical branch network but merely virtual offices.

However, the biggest cost eliminator for the whole system is the fact that they do not carry the loans on the books of the company nor the books of the originating bank.  This conveniently exempts them from building up the corresponding funds to comply with bank capital requirements.

Risks Associated with P2P Lending

At first glance, the advantages of P2P lending for both borrower and investor seem very striking but investors must also take into account several considerations.  Looking at the risks from both investor’s and borrower’s point of view, there are more risks that fall on the side of the investor.

There are laws that seek to protect borrowers including usury laws, regulations against unfair collection practices, deceitful advertising, and discrimination.  All of these still apply to P2P lending.  Whether in P2P or another traditional lending, an investor will always have to deal with borrower credit risk, liquidity risk, interest rate risk, and regulatory risk. Here are some other points:

Your Money is Actually at Risk

Majority of investors in P2P lending may not be aware that the SEC does not cover the money they invest in the platform.  So, if you’re really bent on putting your capital through a P2P platform, make sure you choose your platform very cautiously.

Look for one that is forthcoming about the risks involved and is transparent about their plans plus how they intend to cover your investment in case something goes wrong.

This is Still Technically a Young Industry

While lending is as probably one of the oldest industries in history, P2P lending is still a young industry.  Its track record isn’t at all that deep because it traces its beginnings just during the time of the financial meltdown.  Even if you put together the total experience to the top P2P platforms like Lending Club and Prosper, you still can’t get a convincing range of success record and experience.

This puts to question how investments in these lenders will perform in the coming years particularly when the next recession comes.  Now that they have robust and maturing portfolios, we really can’t say for sure how they can adjust to the times.  One thing is certain though:  during a recession, the credit quality declines across all segments of the industry.

You are Funding Loans Without Any Security

Borrowers who take out loans from P2P platforms do not put up any security for their obligations.  This means that if the borrower defaults, the lender holds no collateral that he can use to pay for the debt.

A borrower who defaults leaves the investors without any recourse – and the slimmest chance to get his money back.

You Pay Taxes on The Interest You Earn

The rule is:  any interest you earn is taxable (except your Personal Savings Allowance).  So, whatever interest you earn from your P2P investment, you have to declare on your annual tax return.

P2P Loan Borrowers Use it For Debt Consolidation

Debt consolidation is a band-aid solution for people with problems of multiple debts.  Most P2P borrowers need money so they can apply this temporary relief for their present situation.  Debt consolidation is far riskier than other types of loans because it’s merely replacing one debt with another.  There is always the possibility of the borrower getting deeper into debt in the future.

In many cases, a borrower wants to consolidate his card debts into one loan.  Once he gets the loan proceeds and brings back his card balance to zero, he might start running up balances on his credit cards again and increase his debts.  As a lender, your risk exposure to this borrower increases.

There is No Secondary Market For Your Investments

Presently, some large P2P companies are doing something about the lack of a secondary market for P2P loans but don’t expect overnight results.  This will be a slow and unpredictable process.  So, if you buy a note for now, you should be ready to hold on to it until its maturity or it’s fully paid.  Some notes will take up to five years which a long time for many investors.  In case you need the cash out of your investment, you would find it almost impossible to find a buyer.

But do take note of this:  in a secondary market, especially through a third-party contract provider, you would have to sell your notes at a significant discount so, you will receive a lot less for them.

Why aren’t P2P lending platforms concerned about the non-existence of a secondary market?  Well, they immediately profit upon the origination and release of the loan so there’s no need to worry about defaults and long waits.

What About Investors?

Investors, on the other hand, must wait for the borrowers to make an actual payment on the underlying loans before they can receive payments from P2P platforms.  On top of this, once the underlying loan defaults and the P2P company recovers some money from the borrower, they will charge a servicing fee before they pay the investors.  This servicing fee goes to the collection agency that the P2P companies hire to run after the borrowers.

As the industry evolves, P2P lending platforms have been trying to lessen the credit risk.  Some are now providing credit scores for every borrower, offering collection services for delinquent borrowers, and assisting in the diversification process through the sale of fractional loans.

Is Peer-To-Peer Lending Right For You?

The first thing you need to do is to determine your risk profile.  Getting 8 percent to 10 percent annual returns sounds really cool but the risk of losing all your investment down the drain is a real possibility.  The point is, do not invest in P2P if you will not be able to bear losing a large chunk of your principal.

Second, check if there are local restrictions on P2P.  For example, the state of Ohio prohibits peer-to-peer lending altogether because they believe that the risk of loss and possibility of fraud is bigger than any potential benefits it could give.

However, if you sincerely believe that P2P lending is the right one for you, then invest in a major peer-to-peer lender that has a track record and is transparent about its process.  Think of names like Lending Club, Prosper, Funding Circle, Upstart, etc. – which share a registration with the U.S. Securities and Exchange Commission.

Also, they have sophisticated tools to evaluate every borrower according to their risk potentials so that, as an investor, you can get sufficient information before you choose which loans to fund.  Also, this does not mean that your investment will flow without a hitch but these factors will help mitigate some of the risks of default.

And last, always go in the direction of diversification.  If you’re putting money into P2P lending, then make sure you don’t put all of your money there.  And be prudent – don’t lend $10,000 to a single borrower.  Split your money into ten borrowers of $1,000 each so in case one or two turns out to be delinquent, you won’t get hit too hard.