I’ve been sharing the passive income from my investments on a monthly basis on this blog, and one of those investments is in Peer-to-Peer lending, which offers returns of over 10% per year. I realize I never really explained what P2P lending is, so in this article I will give a basic introduction to P2P lending and how this actually works. Of ocurse I will also explain the risks and how you can minimize these.
Alternatively, you can also watch the video version here, but if you prefer reading, you can continue below.
What is P2P Lending?
So first of all what is Peer to Peer lending (or simply abbreviated as P2P lending)? Imagine yourself as an individual with some spare money that you want to invest. On the other side there is another individual or a company who needs money. P2P lending simply means that you lend out that money to the borrower who will pay you back with interest after an agreed fixed term.
P2P Lending vs. Crowdfunding
P2P lending is sometimes also referred to as crowdlending, but sometimes it is also mixed up or mistaken for crowdfunding. So what is the difference? Crowdfunding means that a person or organization is collecting money from many individuals but, as opposed to P2P lending, or crowdlending, this is not a loan that needs to be paid back with interest. With crowdfunding this is either a gift, you can attain part ownership, or, depending on the success of the project, you will be among the first to receive a newly developed product, a membership, or other rewards, but no payback of your investment.
So how can you get 10% interest on P2P lending while crowdfunding doesn’t even pay back anything, and banks are paying next to no interest on your savings?
The traditional banking model
To understand this let’s first have a look at the traditional banking model. Traditional banks get their money from central banks and leverage the savings from their clients to issue loans. This is a highly regulated environment where banks are required to adhere to many rules and keep a minimum deposit ratio. This makes banks very thorough and strict when it comes to issuing loans, resulting in bureaucracy and lengthy processes and many loan applications end up being denied.
The origins of P2P lending
Before comparing this to P2P lending, let’s first go back to the 1970s in rural Bangladesh, where the first idea of P2P lending was born.
People in rural villages were having a hard time and were unable to get any bank loans because they were poor and of a lower caste. However, Muhammad Yunus started to lend out small amounts of money to some hard-working villagers who needed some cash, for example, to buy some cattle, a plow or raw materials to produce goods that they could sell. These small loans made a disproportionate impact on poor people’s lives, who were not deemed creditworthy by banks. To his surprise, most of them actually paid him back with interest and this is where the idea of microcredit was born. Yunus went on to start his own microfinancing bank, Grameen Bank, and later received the Nobel Peace Prize because of his impact on social and economic development.
Fast forward a few decades we see a fast growing number of alternatives to bank loans, like bonds, investment companies and funds, angel investors, and venture capitalists. However, the reality is that many of those alternatives are not easily available to most people who either need money or want to invest.
Since the mid-2000s, the technological developments in the fintech sector have changed this with the introduction of Peer to Peer lending. A single website is able to connect many different investors and borrowers in different countries around the world.
So why can you earn 10% interest on P2P lending? The answer is simple: P2P lending operates mostly online and outside the regulated banking sector, making it much more cost-efficient. The approval process is usually much faster and some people or companies who can’t get a loan under the strict criteria of a bank can get a loan this way. The interest rates are not related to central bank rates, as they are simply determined by supply and demand. And since the risks are higher than with your bank account, the rewards are higher too. In the P2P market, interest rates typically vary between 4 and 20% and depend on the individual markets and associated risks.
How does P2P lending work?
So how does this work in practice? Someone in need of money requests a loan from a lending company. After some checks and due diligence, the loan is placed on the P2P website so investors can see it. You as an investor can then invest in the loan after which your money is transferred to the borrower by the lending company. When the agreed loan period ends, the borrower pays back the principal with interest to the lending company. After deducting their profit margin, the lending company then transfers your initial investment, plus the agreed interest back to you.
In this case, everything depends on whether the borrower is able to pay back the loan and if not, you could lose 100% of your investment. Luckily the technology behind P2P lending, makes it easy to spread your risk by breaking up each loan into small pieces so you don’t have to lend the full amount to the borrower.
If the total loan is €100, it could for example be broken up into pieces of €10 so 10 investors can each invest €10 into this loan. And if you have €100 to invest, you can diversify this into 10 different loans.
Sometimes the lending company and P2P platform are the same, but in many cases, they are different companies. In that case we talk about a P2P marketplace, where different lending companies, also called loan originators, can place their loans. This adds an additional step, but creates more options to diversify your investments.
Let’s go through the steps one more time to explain the total landscape. You have a P2P marketplace with different loan originators, who each place loans from their borrowers on the platform.
The P2P platform also has many different investors who each spread their money across different loans from different loan originators. Each loan is then paid back with interest, after which the loan originator and the platform each keep a profit margin and each investor receives back their share with the agreed interest.
The more money you invest the more work this becomes if you invest in each loan individually. Imagine trying to invest €1000 or even €10.000 by investing €10 per loan manually. Therefore most platforms offer an autoinvest option which usually offers several settings so you can determine your own criteria and once activated, your funds are being invested automatically when loans become available that match your set of criteria.
If you invest in P2P loans now you probably won’t help someone in rural Bangladesh buy bamboo to make furniture like Muhammud Yunus did, so in what types of loans can you actually invest nowadays?
Each platform and lending company is different, but here are the most common loan types in the market:
- Consumer or payday loans: These are small loans, usually between €100-€1000 with a short maturity of <30 days and up to a few months, which are issued to consumers who need cash quickly.
- Car loans: Consumer loans with a car as collateral, usually with a loan period of 6 months to 3 years.
- Business loans: Loans to a company who needs cash for anything from financing operating costs, to investing in new ideas, products or other ventures.
- Real Estate: Real estate loans are used to finance the purchase, development or refurbishment of a property and are usually collateralized with a mortgage on the property.
Risks of P2P lending
Off course the high interest rates come with high risks as well. P2P simply is a risky investment type, but by fully understanding each risk and doing your homework before investing, you can significantly lower the risks and bring them in line with your risk appetite and expected returns. So here are the most important risks to be aware of.
Of course the most obvious risk is that the borrower is unable to pay back the loan.
Loan originator default
Another risk is that the lending company is unable to fulfill its duties so it’s very important to make sure that the company is in a good financial shape and has a proven track record.
Investing in another country can also pose an additional risk, which varies per country. Think about the political and economical situation, but also regulatory differences or changes might form an additional risk.
When you invest in loans in another currency, the currency fluctuations form another risk. If the currency in which you invested goes down, you might end up with a negative return. If the loan originator issues the loan in another currency to their clients than they list it for on the P2P platform, they basically cover the currency risk, but this doesn’t mean that you can ignore this risk. If the currency devaluates too much, they could get in trouble and default on all their outstanding loans.
This is actually self inflicted and therefore easy to prevent. If you put all your eggs in one basket by investing everything on one platform, via one loan originator and maybe even everything in the same loan you’re basically gambling. But by using some diversification among loans and loan originators, countries or even use multiple platforms you can significantly lower the risk.
Types of guarantees
A defaulted loan doesn’t always mean that you lose all your money as there are a few guarantees that could be applicable.
Loan originators can offer a buyback guarantee on loans, which means that they will pay you back no matter if the borrower paid them back or not. Buyback guarantees have more or less become the norm with uncovered consumer loans. Of course a buyback guarantee is only as strong as the loan originator’s ability to hold up to it.
Some loans are covered by a collateral that could be sold to cover (part of) the outstanding loan obligations in case the borrower defaults on the loan. This is often applicable to real estate loans and car loans.
Personal plege or guarantee
In some cases, usually when it concerns a business loan, the borrower can offer a personal pledge or guarantee, meaning that he or she will have to back back the loan from their own pockets if the company is unable to do so.
Loan Terms & Liquidity
If you decide to invest in P2P loans, it’s important to understand the liquidity of your investment, or in simple terms, how quickly can you get your money out again.
First of all this depends on the loan type and duration. Some loans are repaid at regular intervals, while others are only paid back in full at the end of the loan term. So in most cases you should not expect to get all of your money back before for the end of the loan term. You can find short-term consumer loans of 30 days or less, but real estate or business loans typically have a duration of up to 2 or 3 years.
Some platforms also offer a secondary market on which you can sell your loans to other investors, but expect to sell at least at a discount and sometimes a small fee is applicable to. There are also P2P platforms which offer more liquidity at lower interest rates, like Bondora Go&Grow and IuvoSAVE.
If P2P lending is something for you, you will have to decide for yourself. If you want to know on which platforms I’ve invested my money and how my portfolio is doing, then check out my monthly portfolio updates. If you want to sign up with any of those platforms, make sure to check out the bonus offers for new signups.