Risk is an inherent feature in any business. You cannot talk about a business without talking about risk. And there is no such thing as a risk free business. Just look at oil. Who would have thought a time would come when it would be cheaper than milk and water (Business Insider)?
While it is true that risk cannot be eliminated, it can be minimized to acceptable levels. What is an acceptable level of risk is a subjective question and its answer will differ from investor to investor.
So is peer-to-peer lending a risky business? Should you invest your savings in peer-to-peer lending?
How is your investment protected by peer-to-peer lending platforms?
There are many platforms for investing in peer-to-peer lending. Each platform has their own way of conducting business and therefore a different approach to managing and mitigating risk.
But we can narrow down the risk mitigation process to four main steps. Let us delve into their finer workings by looking at which peer-to-peer platform use them.
Screening at the door
Effective screening of borrowers is the first and mandatory step for each and every reputable peer-to-peer lending platform.
The basic screening is to check what source of income a borrower has and will they be able to repay as per the schedule. Secondly, most platforms, besides having their own algorithms, utilize major credit agencies and run background checks on individuals applying for loans. Zopa is a prime example here. Zopa uses Equifax, Call Credit and other agencies to check credit histories. Also all borrowers have to have a UK address for the past three years minimum.
Some platforms also allow businesses to apply for loans. Businesses are also screened. Let us take the example of Funding Circle here. Businesses have to show a turnover of at least £50,000. They also should have been in business for two years minimum with filed or formally prepared accounts available.
Diversification
Most platforms have a must policy of diversification. Your investment is split over multiple loans. This ensures that a single bad debt does not wipe out your investment. For example Funding Circle ensures that your investment is split
into a minimum of a 100 loans and one loan never exceeds more than 1% of your investment. While Rebuilding Society does not lend more than £2,000 to any one business.
Secured Loans
Rebuilding Society provides secured loans to businesses. Secured loans ensure that in the event of a default the investment and interest is recovered. Businesses vying for loans under £50,000 have to give a personal guarantee. Loans at £50,000 and above are secured against assets. In case of a default the charge against asset leads to the sale of the asset and the proceeds ensure that the amount of principal and any interest outstanding is recovered and paid to the investor.
Wellesley & Co adopt this model, lending to property developers where the Loan-To-Value is below the asset’s full value, ensuring it can be sold to cover any shortfalls in repayment. Find out more here:
Provision Funds
What happens if the amounts recovered after default are not enough? Well many platforms have a provision fund exactly for this situation. For example, RateSetter (Rate Setter Provision Fund) has maintained an impressive provision fund of over £17 million. This figure is 137% of the estimated claims. Meaning they can pay all expected claims and still have a lot of money left in the fund. This fund is generated by taking a small fee from borrowers and funnelling it into this fund.
Conclusion
Every business has inherent risks. What is important is how these risks are tackled. Most reputable peer-to-peer platforms have most, or all, of the above risk mitigation methods in place and have proven consistently that they work.
Platforms like Funding Circle have had defaults percentage of less than 1%. This was enough to make established banks green with envy.
To put it in a nutshell you have to research and read well before investing in peer-to-peer lending platforms. There are also independent and objective peer-to-peer lending platforms that can help you to compare the merits of different lending platforms. Research well and you shall reap safe, consistent and good returns on your investment.
