Understanding the risks of peer-to-peer lending
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 9%. 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.
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, which protects deposits up to £75,000.
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 P2P platforms have sought to mitigate the impact of defaults by creating provision funds that can be used to reimburse lenders.
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. Ratesetter, for example, has a ratio of 1.3, so its provision fund can cover expected losses 1.3 times over.
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.
‘So far, no investor has ever had to wait to access their money, but it’s a risk that investors should be aware of on all peer-to-peer lending platforms: early access is not guaranteed,’ explained Cyrille Sallé de Chou, RateSetter’s chief risk officer.
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? 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.
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.
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!
- Read part 1 of our brief guide, Five reasons to consider peer-to-peer lending.
- Read part 3 of our brief guide, Maximising the benefits of peer-to-peer lending.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
The Financial Services Compensation Scheme is the compensation fund of last resort for customers of authorised financial services firms. If a firm becomes insolvent or ceases trading, the FSCS may be able to pay compensation to its customers. Limits apply to how much compensation the FSCS is able to pay, and those limits vary between different types of financial products. However, to qualify for compensation, the firm you were dealing with must be authorised by the Financial Services Authority (FSA).