5 Ways To Reduce This Hidden Cost In P2P Lending

By Matthew Howard on 25th August, 2017 | Read more by this author

There's a hidden cost that we at 4thWay have not given much attention to so far, but we've just had an email from one of you about it. It's called “cash drag”.

Cash drag is when you have money sitting in your P2P lending account that is not being lent. It's in cash, just not in your own bank account. So it's earning you nothing, whereas if it was in a savings account it might at least be giving you 1% to 2% interest.

What you need to know about cash drag

Let's say that the interest rates you earn when lending are 6%, but, on average during the year, half your money is sitting as cash in your lending account with no borrowers available. With just half your money being lent and the other half in cash, it means you're actually earning just 3%.

That's an extreme example. Cash drag is not usually anything like that much. In fact, it typically reduces a 6% rate down to between 5.4% and 5.8%.

Importantly, while cash drag lowers the interest you earn, it also lowers your risks. When your money is not being lent it is being held by the P2P lending site in a separate bank account just for lenders at a high-street bank. Accordingly, your unlent money is usually protected by the government under the Financial Services Compensation Scheme, up to its usual limits. That can protect you from the bank itself collapsing.

Cash drag is therefore risk neutral, even if the reduced interest jars at you.

Cash drag is not equal all the time across P2P lending sites

Cash drag varies at different P2P lending sites.

It also varies based on circumstances at the time: if there are currently lots of lenders competing to lend to not enough borrowers, cash drag will be higher, because you have to wait your turn.

P2P lending sites go through what many of them call a “seesaw” in attracting borrowers and lenders. This seesaw is stronger or faster at some P2P sites than others, and it is perhaps more noticeable at smaller sites.

One P2P lending site that, anecdotally, is currently at a low point for lenders in the seesaw is Growth Street. Growth Street's exceptionally strong offering appears to have attracted lenders at a rapid rate in recent months, and some of these lenders have complained vocally on discussion boards and by email to 4thWay that they can't get their money to work.

Zopa's cash drag was so severe at one point that the P2P site took the sensible decision to put a halt on new lending for a while. This drag lasted so long that it is not so much a seesaw as a feature of Zopa. Yet it is a potential sign that it's not recklessly approving loans just to sign up new lenders and make more money.

How to reduce cash drag

I absolutely do not think that eliminating cash drag should be one of your main criteria for picking P2P lending sites. The impact of it is generally too small compared to other factors and over time it will usually all work out fine, provided you are spreading your money across a lot of low risk P2P sites.

That said, here are five options:

1. Even out the cash drag

You can do this by lending to lots of different P2P lending sites, large and small, doing different kinds of loans. This reduces the chances of lots of your money sitting idle all at the same time.

2. Use some P2P lending sites that ask for your money only when it is needed

Some P2P lending sites allow you to send the money only after a borrower is approved and enough lenders, including yourself, have pledged to lend to in that loan.

Our detailed comparison tables have pointed out to me the following that do that:

These sites don't necessarily eliminate all cash drag, as you might expect. Partly because you might have to transfer your money from a savings account to your current account and then to the P2P lending site, and wait for all the rest of the lenders' money to arrive too.

It's also because those borrowers will usually pay you interest on a regular basis. Unless the P2P lending site pays your interest direct to your bank account, the interest you've earned could sit in the P2P lending site's segregated bank account for lender cash. You can, however, simply withdraw the interest regularly for yourself.

3. Use sites that pay interest even when your money is not being lent

4. Avoid sites that have reported high amounts of idle money

Unsurprisingly, P2P lending sites are less quick to tell us about high cash drag than they are to show off about low cash drag. Estate Guru and Rebuildingsociety are two we know of, although our information on those two is now very out-of-date.

Rebuildingsociety is an example of where money that is sitting – or was sitting – idly as cash isn't always a clue about lack of lending opportunities.

It once told us that 21% of money on its site was unlent as cash and yet there were lots of loan parts available to be bought on the secondary market at that time. Idle money can therefore indicate other factors, such as a lack of quality loans.

5. Lend in pre-funded loans

Many P2P lending sites have active resale markets, aka secondary markets. You can load money up to those sites when you see there are lots of opportunities to buy loan parts off existing lenders.

Some other sites, by default, always allow you to lend in loans that have already started. Typically, these sites have partner businesses that fund the loans originally, so that the borrower doesn't have to wait. The loan parts are then offered to through lenders on the P2P website. These include:

These sites still have some cash drag due to the time it takes for you to transfer the money to the site and also because you can receive interest payments that you can't lend out straight away.

The bottom line

Accept some cash drag is inevitable, and that at times  it will be higher, especially if you want to sensibly diversify to lots of different P2P sites. Over the long run it will even out very nicely and it is not a major factor in P2P lending.

Read about the main hidden cost in P2P lending that is much larger than cash drag.

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