You have heard about p2p lending and like the concept. Here are 10 things to consider, when you start:
Advantages of platforms with a track record
I prefer platforms that have a track record and have operated at least 1 or two years. While the p2p lending sector is nascent in total, it is useful to be able to see the performance the platform has delivered so far, rather than only projections and estimates. Obviously past performance offers no guarantee about future yields, but a platform that has operated for some time, will have eliminated operational flaws and IT bugs that might exist right after start. Most important, it is possible to read reviews and opinion voiced on the web by other investors.
Loan term and loan types
Two main questions are the term you want to lend for and the type of loans. Investors usually cannot cancel investments once committed and need to hold the loan until maturity, unless they are able to sell to another investor on the secondary market (see below). So money is tied in (illiquid) for the term of the loan. However many platforms use amortised loans, meaning part of the capital and interest is paid each month.
There are three main types: consumer loans, SME loans and property secured loans. SME loans has further subtypes like invoice financing. It can be a good idea to diversify over different loan types and different platforms.
Diversifcation is an important point when investing in p2p lending. When you spread your investment in small chunks on many, many different loans on a platform, then you reduce the probability that your portfolio is an outlier compared with the average portfolio performance on the platform. So, the more you diversify the more you reduce the probability of your yield being much lower (or higher) than the average yield of portfolios on the platform. Lending Club explains it with a graphic here.
Diversification can be achieved faster on platforms with very many comparable consumer loans, and will take longer on property platforms which launch only few large property loans.
And it sounds more time consuming than it actually is, as most platforms offer an autoinvest feature.
Autoinvest is a feature, where you once set up the criteria for the loans you want to invest into (e.g. the loan duration and the minimum interest rate) and then the platform automatically allocates your money into matching new loans, once they arrive, provided you have enough cash in your account.
Before you use the autoinvest I suggest to spend the first days/weeks making manual investments on the primary market to get a better understanding of the loans on offer.
Also on some platforms some investors prefer to examine loans themselves before investing and never turn on autoinvest.
On a secondary market investors can sell and buy loans to and from other investors. Some operate on par value of the principal only, while others allow sellers to list their loans at a premium or a discount. The secondary market does not guarantee that you will be able to sell the loans at the time you desire, as there always has to be another investor that wants to buy at the same time. So liquidity is subject to change and often demand on secondary market fluctuates. Sometimes there is more seller demand and sometimes there is more buyer demand.
Before you use the secondary market, I suggest you first spend some time investing on the primary market to deepen your understanding of how the platform works.
If there are loans on sale at discount, then surely the seller has seen some reasons that made him list them at discount.
Investors only earn interest on money invested into loans. Cash deposited, but not (yet) invested will earn no interest. The time it takes to get money invested into desirable loans is therefore an important influencer on the yield and depends on the dealflow of the platform and the investor demand. On many platforms there is more investor demand than loans available. This leads to some platforms imposing maximum bid restrictions or operating queues for allocation.
Another factor is the time it takes from making a bid for a loan to the time that investment starts earning interest. On some platform it is instant, interest accrues from the day you invest, on other platforms there are delays – it takes a few days for the loan amount to fund, then it might take some more time till money is paid to the borrower and only then does interest start to accrue.
Unsecured vs. secured loans
Consumer loans listed on platforms are mostly unsecured (exception some car loans). SME loans offer no or or some type of asset as security and property loans typically offer a first or second charge on the property as security. Usually it is preferable to lend with some kind of security offered. However even with the property offered as security there is still the risk that when the loan defaults, the property fails to sell at a price high enough to be sufficient for full recovery of the loans principal.
Some loans come with personal guarantees of the directors. I don’t view these as adding security as they have been worthless in recovery attempts on many past loans.
Some platforms operate a discretionary provision fund. They accumulate small fees into that fund and if a loan defaults, affected investors are reimbursed from the fund. Obviously this will work only as long as the actual default levels are in line (or lower) to the assumptions the company made at the time it designed the provision fund.
Some Eastern European platforms (or the loan originators present on them) offer a ‘buyback guarantee’, promising to buy back the loan from the investor, once it is x days overdue. This promise is only as good as the profitability of the one making it. There has been at least one case where it became worthless when the loan originator went into insolvency.
A certain percentage of loans will default. This is normal in p2plending and nothing to worry about as long as this percentage stays in a healthy relationship to the interest offered for the risk. The platform will initiate a defined process once loans are overdue or defaulted. Make sure you understand the process and are familiar with the average recovery rates achieved.
With very few exceptions, p2p lending returns are taxed in the country where the investor lives according to the rules of that country. If the country you live in does not allow you to offset default losses against interest income earned, it may be a good idea to invest into loans with lower interest rates, but also lower default rates, to achieve higher returns after tax than with a more risky strategy.
If you are lucky position (in a pure p2p lending sense) to be a resident of the UK you have the option to invest up to 20,000 GBP tax allowance in a tax-sheltered IFISA product (see comparison).
Be sure you understand the tax implications and if you are unsure consult a qualified tax advisor.
Start slow. P2P lending has somewhat of a learning curve. It is easy to get excited and carried away early on. I suggest to start with a small amount, gain some experiences and decide whether it is for you and then increase your deposits over time.
Liked these tips? Sign up for the P2P Banking notification services (see yellow boxes) where we inform you once there are news. Want a cashback bonus to start? While you should not select platform by who offers a bonus, it is certainly nice to take it, if you wanted to start with that platform anyway.
This article is neither investment nor tax advice. Investing in p2p lending is risky and bears the risk of total loss of investment