The Five Key Risks In Peer-To-Peer Lending
This page was last updated on 17 January, 2019
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Here is a list in priority order of the key risks in peer-to-peer lending, including P2P IFISAs, and how we as lenders can all reduce those risks.
Risk 1: yourself
The biggest risk in every kind of investment since forever has always been what happens in our own noggins: we get greedy when we should be cautious; we're afraid when we should be greedy. We call this “psychological risk”.
Those who rub their hands with greed at the money they might make tend to be more active investors who pick and choose, buy and sell more regularly.
However, the vast majority of people who actively try to get an edge to boost their returns actually do far worse than others who invest passively from a distance. (See side box.)
This applies to people a lot smarter than me too. We've seen engineers, mathematicians and accountants lose serious amounts of money. We even know a professional investment journalist who lost it all, because he didn't follow his own advice, got greedy and put all his money into a single big bet.
Investing is actually simple, once you've done enough digging to understand it. It's greed, fear and pride that kill you.
It is always at the point where the last sceptic is saying “This time it's different; it is a completely safe bet and this time, for a change, the only way is up” – that's when everything invariably collapses in an almighty crash on all the people who got greedy, leaving sensible lenders and investors to make a big profit from what's left.
It doesn't happen to all investments. In the P2P world, for example, it will just be the P2P lending sites that lose their heads and their discipline, slackening their standards because “nothing has gone wrong before” and because the management at some of those businesses believe they have to keep growing beyond reason to earn their fat bonuses. We've seen it many times before, most recently in the sub-prime property bubble of 2008.
So ignore the crowd, the pundits and what the P2P lending sites are chanting about doom or euphoria, and set some of your own standards that are easy to follow.
For example, for property lending you might set simple rules like:
- Just lend against properties that are being rented out by experienced landlords.
- Every loan must be less than 80% of the property value.
- The rent the landlord is receiving must be at least 1.25 times the total loan (mortgage) repayment on every loan.
Stick to your rules through thick and thin – even if some P2P lending sites themselves don't do so. The key way to prevent your emotions secretly nudging your decisions is to just lend in P2P lending opportunities that pass all your criteria in a checklist. You could start by using 4thWay's 10 P2P Investing Principles.
Risk 2: not enough diversification
If you lend to one borrower, it might not matter how brilliant the P2P lending site is at assessing loan applications, you could get unlucky and lose all your money. (Unless there's a reserve fund to cover losses, but that's another story.) This is called “concentration risk”.
You must spread your money across lots of loans. The impact of spreading your money out like that is simply incredible. Spreading your money across 100 prime loans reduces the risk of suffering large losses from bad debts to a minuscule fraction of the risk compared to lending to just one borrower.
We're not kidding. The maths is mind boggling how the risk shrinks from spreading your money around.
You should also spread your money across several peer-to-peer lending sites. This doesn't just reduce the risk of suffering losses from bad debts; it also reduces other risks, such as risk of losing money due to a P2P lending site going bust or, worse, it acting fraudulently.
(If you use IFISAs, here's how you can still spread and reduce your risks in IFISAs quickly, even though you are restricted in the number of IFISAs you can open.)
As a rule of thumb, aim for 6-12 P2P lending sites and hundreds of loans. These two steps will hugely reduce your risks.
Risk 3: losing money due to bad debts
Now we're halfway through the list and we've got to the most “commonplace” reason for losing money on some loans: when your borrowers aren't good enough and can't pay all your money back. This is called “credit risk”.
When loans go bad, you generally expect that the interest you earn from your good loans is enough to cover any losses. Sometimes you have additional protections too. The loans might for example be secured on the borrowers' property, which can now be repossessed and sold. Or the P2P lending site might have a pot of money set aside to pay expected bad debts.
If enough loans go bad though it could in extreme cases and at weaker peer-to-peer lending offerings, overwhelm all these defences, leaving you with a loss. During recessions or other financial crises, the risks of suffering losses goes up considerably.
Some P2P lending sites are far more competent than others. Some do not conduct all the appropriate checks (such as credit checks or physical inspections of properties from an independent surveyor). Others deliberately look to arrange higher-risk loans, usually trying to accompany this with higher interest rates. So the risks vary wildly from one P2P site to another.
All that said, the risk of large losses is, on average, lower than the stock market. In addition, you can hugely minimise these risks. You could start by following these eight steps.
Risk 4: losing money due to a P2P lending site going bust
We're now getting into lesser risks in that they will impact far fewer people. This one is about peer-to-peer lending sites and IFISA providers going bust. This is called “platform risk”.
If one of the P2P lending sites that you use collapses, there is a substantial risk that you may experience delays in getting your money back.
There is also a risk that you will not get all of your money back. Although there are bound to be a few real disasters, the risk of that is actually relatively small compared to the risks above for three big reasons:
Ringfenced loans are still owed to you
Dozens of legitimate P2P lending sites have gone out of business already. That is normal for a relatively new industry that is still bedding in. Most of these P2P sites were small and never really got off the ground, but some of them had started matching borrowers and lenders together.
So far, it looks like most individual lenders are not out of pocket from these events. The prime reason for this is a direct relationship between borrowers and lenders: the P2P lending site is just an agent in the middle. You have been lending directly to each borrower, and each of them still owes you your money and needs to keep meeting repayments.
Direct lending like this also means that the P2P lending site's own debts should be ringfenced. This means if the P2P lending site goes bust while owing money to Barclays Bank, Barclays can't elbow in and take over the loans that you are owed.
That ringfenced, direct lending is your first line of defence and it is a very good one.
The industry's regulator, the Financial Conduct Authority, has warned that sometimes, in practice, not all P2P lending sites' will currently ensure that their own debts and financial troubles cannot get mixed up with the money individual lenders have outstanding. However, we know of no case in closed, regulated P2P lending sites where that has happened.
UK P2P sites are required to have funded wind-down plans
In another substantial line of defence, P2P lending sites authorised in the UK are required to have wind-down plans that are fully funded and the FCA is committed to strengthening those further over time, and ensuring that P2P lending sites start providing full information about them so you know exactly what will happen to your money.
If the wind-down plans are reasonable, a P2P lending site should be able to continue to administer and wind down existing loans smoothly, repaying you your money until all the loans are cleared.
The costs of winding down a loan book are usually relatively small, since it largely means just administering loans until they are full repaid. Some of the big costs in P2P lending are in the costs of attracting borrowers and lenders, and in assessing borrowers to see if they are worthy of a loan. You can expect both these costs to disappear instantly on a P2P lending site going into “wind-down” mode.
While smaller operations are at greater risk of not making it, their costs are even lower and the founders will often be able to wind down their small loan books themselves in their spare time.
P2P sites need to have at least £50,000 in cash set aside to fund the wind down, even after they have been taken over by bankruptcy administrators. The amount a P2P site needs to set aside is even higher if a lot of money is lent through it.
Administrators will also take over any fees and interest that the P2P site itself was due to earn, and can use those fees to fund itself while winding down your loans.
The interest you earn provides additional protection
If it turns out that none of those above safeguards are sufficient and that funding is a bit short, the administrators might shave off some of the interest that lenders were due to receive on loan repayments.
If the costs of running down the loans spiral beyond even that, lenders might finally lose some of their original loans.
However, even now, we do not think this is usually likely to be the whole pot of money or anything even close to that amount. Consider that when a bank lends £1 million, it doesn't cost the bank £1 million to administer those loans. That's the same in P2P lending because the same processes are being used (or, in some cases, modernised, sleaker, more cost-effective processes).
So we might just get back, for example, 90p in the pound. A few years’ of P2P interest payments would cover that, or might have already done so if you have been lending for a while.
To further reduce your risk of losing money from a bust P2P lending site
- Avoid P2P sites and IFISA providers that show enough signs that they might be approaching imminent collapse.
- Lend across several different P2P lending sites. If just 1/5 of the P2P sites you use both goes bust and just return 90p in the pound, that works out at just a 2% loss across all five platforms. Lending interest you earn will easily cover this.
- You coud look out for reports that the P2P site appears to be either profitable, well funded, well backed by investors, or cheap and simple to run.
- If you're familiar with company accounts, there can be indicative nuggets or even solid reassurance in those, even in the case of private businesses, which put less information in their accounts than public (stock-market) companies.
- Look for peer-to-peer lending sites that are regulated by the UK's Financial Conduct Authority.
- Take steps to work out of the P2P lending sites do direct lending. Some websites that describe themselves as P2P do not actually offer direct, ringfenced lending, but 4thWay only lists sites that appear to offer that kind of genuine, “pure” P2P.
We must expect that there will be the occasional bad egg that collapses and does worse for lenders than expected. However, that is most likely to happen when the collapse also involves risk five on our list…
Unlent cash of yours in your P2P lending account is held in a separate high-street bank account just for lenders. This money is yours and will be returned to you. In addition, £85,000 of your unlent money is normally, but not quite always, protected by the government through the Financial Services Compensation Scheme, although this limit is shared between all the rest of your current and savings accounts at the same high-street bank, and sometimes with other brands in the same banking group. For joint accounts, the limit is £170,000.
To be clear, your money that is currently being lent is not protected by this scheme. No investments ever are or we'd all just bet on crazy things!
Risk 5: losing money due to fraud or negligence
All types of saving product or investment, from the stock market to property to savings accounts and beyond, attract some fraudsters or even people who commit criminal (or near-criminal) negligence. P2P lending in the UK will be no different.
In the UK, while fraud and serious negligence will occur far less often than P2P lending sites going bust, the losses you will make if you are sucked in to such scams are likely to be much bigger.
More P2P lending businesses will rather go out of business than commit fraud or gross negligence to survive, but you could expect the consequences of fraud to be more severe on your wallet.
There are often many tell-tale signs to look out for. The more of the following you spot, the more likely it is that you are being targeted as a potential victim:
- No entry on the Financial Conduct Authority's register. (Read How To Check The Financial Services Register For Monsters.)
- Not showing on prominent websites such as 4thWay.
- Poor quality website.
- Poor English on the website and materials.
- No opportunity to contact them by telephone.
- Claiming to be expert while not revealing much information about what they're doing.
- Highly aggressive marketing language, i.e. talking down the risks while talking up some glittering rewards.
- (If you can read company accounts) lots of question marks about their business or finances, including small companies making losses while paying very high director salaries.
This was part four of our ten-page P2P lending guide
- Read part three: 4thWay's 10 P2P Investing Principles.
- Read part five: 4-Step Strategy to Safe Peer-to-Peer Lending.
- See the contents of the whole guide.
- You might also be interested in: IFISAs: What Are The Risks?
- And: The 3 Huge P2P Lending Mistakes You're Making Now.
Independent opinion: the opinions expressed are those of the author and not held by 4thWay. 4thWay is not regulated by the ESMA or the FCA, and does not provide personalised advice. The material is for general information and education purposes only and not intended to incite you to lend.
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