Do you want to know exactly what the Peer-to-Peer lending risks are? Is it safe to invest in P2P lending and what are the steps you can take?
When you’re investing your money, there is always a certain risk involved. P2P lending is certainly not exception to the rule.
When you’re considering to start investing in Peer-to-Peer (P2P) lending, you should be aware of the Peer-to-Peer lending risks. Crowdlending is something that can lead to much higher returns compared to other investment vehicles. Mostly, when you have higher returns you have a higher risk. Although it might not feel like you know what the scary stock market is doing, it might be more consistent over time.
I’ve written quite some articles about P2P lending, including:
- 9 Best Real Estate Crowdlending Platforms
- Top P2P Sign-Up Bonuses & Cashback Links
- Mintos – a big and stable Peer-to-Peer lending platform. When you sign up using my link, you get a bonus of 0.5% of your invested amount in the first 90 days!
It would make sense to dive deeper into Peer-to-Peer lending risks since there is a variety of risks that can be associated with investing in P2P platforms. These risks are important to take into account when you want to make P2P lending a part of your portfolio.
When we are analyzing Peer-to-Peer lending safety, there is a variety of risks with different impact on your investments:
- Money drag – the money you have is not fully invested in projects.
- Borrower default – the borrower defaults on the loan you have invested in.
- Loan originator bankruptcy – the loan originator is not able to fulfill its obligations and goes bankrupt.
- Platform bankruptcy risk – the P2P lending platform goes bankrupt or stops its business and defaults on all the loans you’ve invested in.
- Economics risks – macroeconomic movements like an economic downturn or political uncertainty can move the entire market into a different direction.
The Peer-to-Peer lending risks are very serious and you should certainly attend to them. Let’s dive straight into Peer-to-Peer lending risks – and how you can diminish the risk you’re taking!
P2P Lending Risk #1 – Money Drag
Money drag means that your money is not fully invested, this is the risk that some of your money is not earning you any income. This is the least serious risk that you have when investing in crowdlending platforms.
When you’re investing in P2P loans, they have different repayment terms. Once the loan has been paid off or you receive interest on the loan, you get money in your account. You will have to re-invest that money in your investment account.
One easy way to do this is by using the auto invest feature that is available on many platforms.
When you’re investing using the auto invest feature and your money is still not invested, it’s possible that there are no loans available that have your desired loan criteria.
Having a money drag is no big financial disaster, you’re simply not investing all your money. Meaning that the money you don’t have invested on the platform is getting you a 0% return on investment.
This is the least serious risk of P2P lending, it’s simply not desirable.
How To Mitigate The Risk?
Money drag is only a problem on a few platforms. While it has not been a problem that I personally have experienced, it is something that investors can experience from time to time.
When you’re using platforms like Mintos, where they have an auto invest functionality, the problem is easy to solve.
In any case, you should check your investments at least once a month. Depending on your preference, you can check your investments more often, for example weekly.
This enables you to know if you’re having a money drag that prevents you from getting an optimal return on investment.
If you notice that a money drag, you can adjust your loan criteria (lower interest rates, longer loan terms, other loan originators, and more) to invest more of your money.
When that doesn’t solve your money drag problem, it might be best to take your money and invest it in another P2P lending platform. I haven’t experienced any cash drag with the platforms I’m currently investing in, like Mintos or Reinvest24.
P2P Lending Risk #2 – Borrower Default
In short: borrower default means that the borrower is not able to pay back the loan.
When you’re investing in peer-to-peer lending, you are loaning money. Depending on your platform, you loan money to an individual or a business.
You can probably imagine that when you loan people or businesses money, there is a risk that the other person will not be able to pay you back. We call this defaulting on a loan.
If this happens, you will probably already have gotten back some of your investment. Of course you want all of it!!
The platform you are investing your money in is trying to get your money back through various legal procedures. However, the risk is that you’re losing your money.
How To Mitigate The Risk?
With many P2P lending platforms, they make it simple to mitigate the borrower default risk.
Why? Because many P2P platforms provide a buyback guarantee, where they buy back the loan from you when the borrower is late with payments (often between 30-60 days late). Most of the platforms also recover for your lost interest rate when this kind of event occurs.
I only invest in crowdlending platforms that offer a buyback guarantee on loans. There are some platforms that offer loans with and without a buyback guarantee, so be sure to choose loans with a buyback guarantee.
When you choose to invest in loans without a buyback guarantee, make sure that you’re doing your own research – and dive into every detail you can find. This way you can determine what is the risk associated with the return you will receive. A general rule of thumb is: the higher the interest rate, the higher the risk (chance of default in this case).
Another way to prevent borrower default is by selecting many different small loans. Doing that prevents that one borrower has a big effect on your returns. I mostly invest between €10-20 in one single loan. For some platforms that are offering fewer and larger loans, it is not possible to invest in many small loans. In that case, I choose to invest the minimum amount possible, which depends on the platform.
P2P Lending Risk #3 – Loan Originator Default
There two different kinds of P2P lending platforms:
- P2P lending platforms that offer loans from different loan originators.
- P2P lending platforms that offer loans themselves (no third party involved) – are often fewer and larger loans.
For the platform that does not use any third-party loan originators, loan originator bankruptcy is the same as platform bankruptcy (the next P2P lending risk).
However, if you are investing in platforms where there are many loan originators, loan originator default risk is an important one. When one of the loan originators you’re investing in default, you may lose many of your investments with that specific loan originator.
When a loan originator defaults, the P2P lending platform is sending their lawyers and try to recover the investment through normal bankruptcy procedures.
It is rare to have a loan originator default, but it has happened once with Mintos. When they default, the damage is big – so you want to prevent this when possible.
How To Mitigate The Risk?
The two most important things to mitigate the risk of loan originator default bankruptcies are: diversify among loan originators, and do your own research.
Diversifying your investment among multiple loan originators is important to minimize your risk of loan originator default. When you diversify your loans, it won’t have such a big impact on your total investment since you’re investing with many different loan originators.
Doing your own research is always important, especially when you want to prevent loan originator default. You can check which loan originator you feel comfortable investing your money with.
A platform like Mintos has their own risk rating of their loan originators. While I think it’s great that they are doing that, not all their research is equally detailed. That’s why I have researched for myself which Mintos loan originators I feel comfortable investing in.
It is very important that you only invest in loan originators with good numbers, where you feel comfortable to put your money.
P2P Lending Risk #4 – Platform Bankruptcy
While all three lending risks that were outlined before are important, we are now getting into the very serious risks of P2P investing.
A platform bankruptcy is a serious threat to your entire investment – when a platform goes bankrupt, you can lose all the money you invested.
How To Mitigate The Risk?
I will repeat myself a bit here, but the advice stays important: do your own research and stick to platforms you feel comfortable in.
Before you invest your money in any platform, you should research them carefully. Different P2P platforms are registered in different countries with different legislation.
When you’re investing in Europe, some platforms might have this loan deposit guarantee, meaning that up to an X amount the government will refund your money when a platform defaults.
Don’t invest in a platform simply because someone you know invests with that platform.
Last February a platform called Envestio got into big trouble – they couldn’t pay back their investors anymore. They took their website offline and since that day no one has heard from them. This is not the only platform that is taken offline over time. Other platforms have falled too.
While the advice until now was to diversify, I would urge you to only invest in platforms you fully know and trust.
I invest in four different P2P lending platforms at this moment in time, and I trust these platforms fully. I only invest in platforms that I fully trust and that are already established in the market. At this moment, I am not concerned about any platform I invest in.
P2P Lending Risk #5 – Economic Risks
Now we’re not only talking about the P2P lending market, but about the entire world economy. There are certain factors that can influence the entire economy, that will certainly hit the peer-to-peer market.
These economics risks are market downturns, political tensions, or perhaps even a global pandemic.
These economic and global risks may influence the ability of platforms and borrowers to pay the money back. We haven’t seen yet how Peer-to-Peer lending platforms will act when there will be another financial market downturn. If there will be people losing their income and loan originators not getting paid, I can imagine that some platforms or loan originators may not make it.
Besides that, interest rates have been historically low for the entire period that P2P lending arose. If the interest rate will rise, people might lose interest in the P2P lending sector and perhaps not find it worth the risk anymore.
These are market risks that arise from macro-economic movements like financial downturns.
How To Mitigate The Risk?
The macro-economic movements and political developments are very unpredictable. In many cases it will hit unexpectedly and there is very little you can do.
There is only one type of investment advice that I would be able to give in that case: never invest money you can’t afford to lose.
It’s far from the ideal situation, but that is the unfortunate truth.
The best way to mitigate this risk is to invest only a small portion of your portfolio in Peer-to-Peer investing. I would say between 10-15% of your total portfolio, this may vary depending on your risk appetite and your personal preference.
Peer-to-Peer Lending Risks – Should I Invest In P2P Lending?
That’s up to you. I do not recommend investing in P2P lending if you cannot afford to lose your investment. If you have money for high risk high return investments (10-20% return), you could consider investing in P2P lending.
Personally, I would recommend investing about 10% of your assets in P2P lending. It is a high risk, high return kind of investment. My current average returns are about 13% and it’s money that I can miss, meaning it’s a risk I’m willing to take.
What do you think about Peer-to-Peer lending safety?