Do you currently have money sitting in the bank earning interest? No? … Maybe you need money right now? A loan perhaps? No?… Maybe you’d just be interested to learn how to earn a easy 12+% per year? Okay, surely I have your attention now…
Traditionally it has been the big banks that have been in the business of handing out loans. They pay money for people to park their money in an account with them and they lend out money to people for a fee as interest payable over the course of the loan. However, in the last decade peer-to-peer (P2P) lending (P2PL) has sprung up and blossomed into a profitable marketplace offering both of these functions at a distinct advantage to both borrowers and lenders.
So, what’s all the hype about P2P lending?
P2P lending promises fantastic returns to those willing to invest in it – some P2PL companies claiming an interest rate in excess of 30 % per annum. This is well, well above the interest you can collect through putting your money into a bank (~ 3% in the US) – even a long-term, high-interest account with all the bells and whistles.
And what about P2P borrowers? Well, they can enjoy a huge discount on the interest rates of their loans compared to what a bank would typically charge.
Just like Uber is able to make it cheaper to get a lift to and from places through tapping the ride sharing economy, P2P lending can make borrowing cheaper through cutting out the expensive middleman – the bank. In fact the banks are so threatened by this new service that some have even launched their own platforms, like Marcus by Goldman Sachs
How does it work?
The advent of P2P is probably as natural as any other kind of sharing economy – such as ride sharing in the case of Uber. P2P services essentially match up those with spare funds they are willing to lend with people who need a fixed loan for a period of time. The time period and interest rate are set and the P2P service collects a fee for providing the service, which is taken from the money collected from the borrower, the balance of which is given to the lender. In reality, money invested is actually broken up and used for many loans in order to diversify away the risk of a borrower default. This brings us to an important question about the safety of this type of scheme for an investor who acts as a lender in the P2P marketplace.
Risks of P2P lending
Basically, if a borrower fails to make on time payments for a loan provided by P2P investors, it is termed loan delinquency. If repayments are more than a certain period (sometimes 120 days) late, it’s deemed a default. Delinquency and default are basically the best way to measure the risks associated with P2P lending. However, delinquency doesn’t mean a loan will ever get repaid – just that the payment of it has been late. Delinquency is generally around 5% for most of the big players in the P2P lending market. However, some of these companies can actually claim a 100% repayment rate on the loans because of what’s known as provisional fund.
A provisional fund is a pool of money, which exists purely to smooth out the operation of P2P lending in the case of delinquency. If a borrower hasn’t payed what is owed, the investor is payed through the provisional fund for the time being. Effectively it’s robbing Peter to pay Paul; the investor gains confidence in knowing the system works and getting their money back on time and the borrower now owes the money to the lending platform instead, so that they end up topping up the provisional fund which has been drawn upon. The provisional fund is great if delinquency rates are low, but if they’re too high it means investors won’t get their money back on time.
P2P lending has developed into a much safer, reliable investment
P2P lending has actually come along way in terms of becoming a much more reputable and safe means for investors to loan funds and earn a reliable return. The oldest of the P2P lending platforms were founded back in 2005 and 2006. These include, Zoppa, which is British based, with Lending Club and Prosper from the US. In the early stages delinquency rates were incredibly high. For example, around 35 % of all loans out of Prosper older than about 1 year were in some form of delinquency as of 2008. The problem stemmed mostly from the platforms having fairly loose borrowing criteria and handing out loan’s way to easily. Following an overhaul around the time of the GFC, borrowing requirements became tighter especially in the US and loan applicants required better credit ratings in order to get approval in the P2P market. Most of the P2P lending platforms will take into account credit rating when dictating the interest payable on the loan, with the riskier applicants paying higher levels of interest, in order to attract lenders. Nowadays, P2P lending is much safer for lenders and is regulated in a much stricter manner.
What are some the other risks?
Aside from worrying about lending money out as an investor and the loan falling into a state of delinquency, there is also the risk that the P2P platform itself becomes insolvent or goes belly-up. Some these companies trade as a public stock on the exchange and if they fall apart financially it’s possible you may lose your money even if the borrower repays the loan. Having said that the P2P model is extremely profitable and the risk of this is quite small but something to consider as a potential investor.
I hope with all that talk of the risks of P2P lending, I haven’t turned you off it. As an investor its important to do your due diligence and know the risks. However, P2P lending has a glowing reputation as a legitimate and highly profitable way of making great interest on your money and getting cheap loans. Stick with a reputable, solid lender who has a good track-record and like all other investments don’t put all your eggs into P2P lending.
What kind of returns are possible?
Well that’s a difficult question to give a plain answer to. Although the claims of double-digit returns are quite eye-catching, they only really applicable under certain circumstances. There is also the matter of how much default and delinquency affect returns since the advertised rates generally don’t factor this in.
As for an estimate of the return, by far the most important is the country you’re and the length of time that you lend over. You’ll earn more the longer you hold the debt, just like other forms of fixed interest such as bonds. As an Australian citizen, most of the P2P lenders offer average rates at around 8% on 5 year loans. In the UK, the rate is lower at an average of 6 % and in the US is around 9% or so. As a rule of thumb, you can obtain much better rates – generally a few % above what a bank would give for the same period of time. For example, in Australia, RateSetter offer 4.9% over 1 year and 8.9% over 5 years, compared to 2.4% from NAB for a fixed term deposit of 1 year.
Another factor which comes into play is the credit rating of the borrower. Using the US P2P lending market as an example, we find that for the two big operators, LendingClub and Prosper, they both generally state that there 6 -36 % per annum return to investors. This a huge range and obviously for a safer, more trustworthy borrower, we’d expect that the returns are lower and then towards that 6% figure and for risky borrowers who have poor credit ratings the returns tend towards the 36%.
This presents an interesting question:
Is it better to play it safe and lend only to borrowers with great credit ratings and collect just 6% per annum as opposed to lending at a higher interest rate to applicants with a strong chance of default? Do the returns justify the risk?
What would be handy is to know what the return would be (on average) even taking into account delinquency/ default. Then we can compare it to other investments, like stocks, CD’s and so forth by knowing how much value this opportunity actually presents.
Fortunately this kind of information is available and using it we can get a much better idea of what the actual returns are. The table of from this link is that of the loan performance, the column we are interested in is ‘adj. net annualized return’. As can be seen, even comparing across all the different loan types categorized by risk, the return is around the same 5% or so figure taking into account defaults and delinquency. It’s worth noting that this figure is for short loans of less than 1-year duration.
So, what does this all mean? Basically, when factoring in chance of default, the return is pretty similar across all credit ratings if we average out, although the high quality debt is a little better. Based on this I would advise taking on high quality debt from good credit ratings (A or B) with lower interest since overall the returns on average the same or slightly better than the other classes (even the high-risk debt yielding up to 36% per annum, with a 25% average return! ).
You may find other P2P networks offering tempting levels of interest as well, but just remember that to invest and receive these returns we have to assume we’re taking on more risk.
Simply put, with P2PL:
- You earn more per annum the longer you lend
- The returns are similar across credit ratings once averaged out for delinquency rates and defaults so you should stick to lower-interest, good credit debt
- P2P lending offers better returns than bank interest and bonds, but we take on more risk to acquire these returns. Still, even on a risk adjusted basis, the A and B grade debt is well worth investing in due its safety (delinquency < 3%) and strong returns (5+% over several years).