How risky is P2P lending?

If you are looking for risk-free investment opportunities, prepare yourself to be disappointed. Despite how wonderful they sound, there are no risk-free investments. 

The fact that investing is not risk-free should not discourage investors from looking into alternative investment opportunities, provided they know how the investment works in detail and the specific risks.

Post summary:

• Is P2P lending safe?

• The 3 risks associated with P2P lending
• 5 tactics to manage P2P lending risk

Is P2P lending safe?

Investing and risk are like a relationship; you cannot have one without the other. Just like a relationship, some are more volatile than others. 

Therefore, investing in P2P lending through peer-to-peer platforms comes with a certain level of volatility in your investments.

Most P2P lending online platforms are regulated by local authorities rather than at an international level. 

However, since P2P lending has become such a cross-border industry, investing in a platform regulated by an authority different from your home country is potentially risky.

One of the most significant advantages of P2P lending platforms is their level of transparency. Many fully disclose how investments’ security and legal structure work and are committed to making P2P investing better and safer.

This, in turn, increases the platform’s trustability and provides investors with valuable historical data about loans and their average returns.

Sadly, several P2P platform scams have knocked investor confidence in using reliable and trustworthy peer-to-peer lending businesses. 

Still, you can determine which to use if you do your homework on the platform, and most platforms are audited regularly.

Investors can then mitigate risks through safeguards, including a buyback obligation and viewing only higher-quality loans. 

Risks associated with P2P lending

The risks of P2P lending can be categorised into three groups:

• Loan defaults and late repayments of the debt

• A loan originator going bust

• The P2P platform itself going bankrupt

Loan defaults and late repayments of the debt

P2P lending is a debt-based investment where investors lend money to individuals or businesses in exchange for a reasonable return on their capital investment.

The borrowers themselves, to whom the investors have lent money must make the loan repayments. However, there are times, particularly during difficult economic circumstances like the COVID-19 pandemic, when borrowers default on making payments or the entire loan.

As the investment returns are dependent on the borrower making these repayments, all of a sudden, your P2P investment no longer makes any returns for you. 

However, this risk can be mitigated if investors use a platform or only lend to borrowers who provide underlying collateral to the loan. So, if a borrower defaults, the collateral can be sold to provide the returns investors seek.

Other platforms provide buyback guarantees.

So, the outcome of a loan default or late repayment differs from platform to platform. 

A loan originator going bust

In P2P lending, a Loan Originator (LO) is an entity that acquires borrowers looking for a loan. 

A loan originator’s role is to provide borrowers with the P2P platform, which only needs to focus on administration and acquiring lenders.

This means that investors lend money to a loan originator instead of directly to a P2P platform. The LO then passes this money on to the borrower. 

The LO also collects all repayments from the borrower, who pays the lenders (investors) via the platform.

As this form of peer-to-peer lending occurs outside of the platform, it provides the business with a streamlined lending model to find newer loans to offer investors.

Sadly, the platform does not guarantee the liquidity of the LO, which means if they go bust themselves, investors are once again left short. 

Whether lending or borrowing money, P2P investors must trust to whom they are lending money so that they will not lose capital or interest repayments should the loan originator go bankrupt.

Hence, even if the loan is through an LO, an excellent P2P lending platform must ensure investors are not impacted by extensive due diligence. 

Due diligence should include financial and legal analyses in approving loan originators to their platforms to minimise the risk of collaborating with a sub-par loan provider. 

Some platforms even have LOs who keep a certain percentage of their loans. If they do this, they will have something at stake and are more incentivised to take new loan originator approval seriously.

Investing in loans through loan originators is a risk, but that does not mean it should be avoided, as they can provide some high-yield returns. 

As always with most investing, ensure you diversify your investments across various loan originators. This will make you less vulnerable to possible bankruptcy should one of the loan originators fail.

P2P platform itself going bankrupt

Like typical businesses, P2P lending platforms need to make more money than they spend; otherwise, they will lose business and may have to close. 

Put briefly, the P2P lending platform you use to invest through could go bankrupt. 

Should this occur, the P2P platform will accumulate the remaining debts from its borrowers and settle with tier creditors, namely any outstanding investors.

To avoid being one of the investors who has lost money on a bankrupted P2P platform, always thoroughly audit the company’s financial health.

Read third-party reviews and avoid those that do not publish their audited accounts. This will minimise any risk to your potential investment in a P2P platform.

Managing P2P lending risk

1. Diversify your P2P platform portfolio

Diversifying investments across multiple loans, loan originators, and even P2P loan platforms is the best way to minimise the risk involved in managing peer-to-peer lending. 

Doing this will help lower an investor’s overall exposure to loan defaults, whether a peer-to-peer lending platform or a loan originator. 

Suppose the P2P lending platform you are investing through is an aggregator of loan originators. In that case, examine each loan originator’s financials before selecting them to invest in. 

2. Diversify investments through other platforms

Experienced investors would never ‘place all their eggs in one basket.’ And this is the same for those looking to grow their capital. 

Unless you have a very high-risk tolerance and are a real expert in peer-to-peer lending, only a small section of your portfolio should be on one platform. 

Spreading the risk amongst platforms and loan originators will also avoid the pitfalls should one suddenly become insolvent. 

3. Avoid being enticed by high rates and search for strict criterion platforms

Investors can immediately lower their risk significantly by opting for P2P lending platforms that are strict with whom they lend. 

Platforms should also underwrite a loan’s credit, affordability, identity, and possible fraud of borrowers before being accepted to the platform. 

That said, even borrowers with excellent credit scores might end up in a situation where they cannot repay their loans. 

Even though good credit scores can reduce the likelihood of a loan default or late debt repayments, investor risk can never be eliminated.

4. Use P2P platforms with Buyback guarantees

A buyback guarantee is an agreement between a lender and the loan originator or P2P lending platform. 

Suppose the borrower is late with or misses a loan repayment for a certain number of days; the loan originator or platform must buy back the loan from the lender.  

The peer-to-peer platform can buy the loan back either fully or partially. Many loan originators offer their type of buyback guarantee with different terms. 

For instance, the days of payment delay accepted before a loan is repurchased might vary. Still, it is usually 30, 60, or 90 days. 

Some buyback guarantees will reimburse investors for the outstanding capital and either partly or in their entirety all interests and fees. 

Others will only compensate a portion of the loan and its costs and interest. 

5. Invest in collateral-backed loans

If a borrower delays their loan repayments, a trustworthy P2P lending site will take steps to recover the debt. Furthermore, it prevents the borrower from entering into further loan defaults and protecting investors’ (lenders’) money.

In this regard, peer-to-peer lending platforms and loan originators can offer different approaches to safeguarding investors’ money. One of those is where loans are provided with collateral provided.

As discussed above, should a borrower default on making payment or default on loan altogether – the collateral they offered when seeking borrowing is then sold to pay back investors.

How risky is P2P lending, then?

Simply, no investment vehicle is ever risk-free.

However, investors can take many different measures and approaches offered by trustworthy platforms to precisely increase the safety of this type of investment. 

Thus, the question is, how safe is P2P lending?

Platforms offer different guarantees and loan diversity to convince investors they will not lose money when investing in peer-to-peer lending.

These guarantees and lower-risk loans serve as investor protection insurance covering them should a loan default or a payment is missed. Thus they do not lose all their money. 

Other ways of mitigating risks in P2P lending come from the investors. 

Principally, investors should diversify their investment portfolio and scrutinise peer-to-peer platforms and loan originators before investing.