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8 P2P Lending Mistakes People Make
While the vast majority of individual lenders have made money on their loans every year since P2P lending started in 2005, some have not done so well.
Alternatively, some might have been surprised by other outcomes, such as seeing their money trapped in for longer than they wanted.
These unfortunate events usually happen when the lender has not understood the key features of money lending or hasn't used simple, universally applicable techniques for lowering risks.
Here’s what some lenders wish they knew before they opened their first P2P lending accounts.
Mistakes related to selling loans (1-4)
You don't ever have to sell your loans to other lenders and it's not the most common way for you to be paid back. Indeed, there are several mistakes related to selling loans that some lenders make.
Some lenders seem to consider the ability to sell loans in an instant for a full return of their money as a sign that a P2P lending company is a good one.
On the contrary, it has nothing to do with the quality of the P2P lending company and it isn't something that even the best ones will be able to offer you 24/7, 365 days a year.
Instant access is what savings accounts are for.
The point of money lending is generally to lend to the borrowers from the beginning and keep lending until the borrowers repay in full, with interest. You'll keep earning interest on your good loans until the end, which doesn't happen if you sell. You then exit your loans for the initial price, not at a discount, because the borrowers repay your initial loan.
Your key strategies related to selling are:
- While you can take steps to increase the amount of money you're able to get back early, you should:
- Plan for holding your loans till the end, as nature intends.
- Lend less – or don't lend at all – if being able to access your money early at all times is extremely important to you. That's what savings accounts are for.
The next four sections are drilling down further into the specific mistakes that people make that are related to selling loans.
1. Selling early to create a loss out of a winning portfolio
We've known lenders complain about suffering self-inflicted losses by selling their good loans before they have earned enough interest to cover any early bad debts.
With some types of lending, or in some market conditions, you might notice that a good proportion of the loans that are going to turn bad do so early on. You'll need to hold on to your good loans and earn more interest to cover both those bad debts and to pay any exit fees or costs.
You might not even have to wait that long, if you expect that a good proportion of those bad debts will eventually be recovered. That could be the case in property loans, if the P2P lending company has built an excellent record of recovery.
2. Selling at a discount, creating a loss
If you have lent too much money in that you absolutely need to get it back early for some other reason, you have chosen to take an unnecessary risk of losses. Because sometimes, if you want to sell early before borrowers repay in full, you'll have to do so at a cut price.
A few of the more common reasons why that might happen are:
- The economy has turned for the worst and those buying loans want to take advantage of people panic selling.
- Lack of demand to buy off you from other lenders, meaning that buyers can insist on a better deal to make sellers compete with each other.
- Lending rates on new loans have risen substantially and so those buying your existing loans want a discount, because the interest rate on your loans is no longer competitive.
The risk of making this mistake is particularly high for people who have lent their money when not truly understanding the loans they are lending in or the quality of the P2P lending companies they're using. Such lenders are the ones most likely to panic-sell quality loans for a loss in a downturn.
3. Trying to sell early and not being able to
Money lending is not designed for instantly selling your loans whenever you want. Most P2P lending companies are able to offer the feature of selling your loans before they're naturally repaid to the borrower. But this is an extra benefit that lenders are lucky to be able to have much of the time.
But not of all of the time. Even the very best peer-to-peer lending companies won’t always enable you to sell early.
The best ensure that those holding on to their loans to the end have an extremely high chance of ending with a profit. That’s their job. It’s not their job to ensure you can always sell. That’s down to market forces: whether enough lenders want to buy and sell.
It’s all about a trade-off. You can sell shares on the stock market instantly, but, in return, prices can fall dramatically in weeks or even seconds. You could sell at a big loss for the privilege of instant access.
In P2P lending, you often can’t sell in those conditions. The P2P lending company shuts down the market rather than see its lenders create self-inflicted wounds at cut prices. You're forced to be more disciplined than stock-market investors.
We at 4thWay consider this a good thing, on the whole! (Although it’s nice for the variety that some P2P lending companies allow you to sell at a discount. Those ones also often allow you to sell for a profit!)
4. Suffering a loss somewhere else because you can’t sell when you needed
Inappropriately relying on being able to sell early can result in harsher consequences than merely being forced to earn interest for a longer period of time!
The risks you create for yourself in “3. Trying to sell early and not being able to” are compounded if you need the money back early for financial reasons.
Let's say that you're saving for a deposit on a house and you're just a few short months away from being ready to buy. You probably shouldn't have most of your deposit money invested in P2P lending. You might miss your chance to put the deposit down on a great property you find and, in the meantime, house prices will rise further while you're waiting to get your money out of P2P loans.
Potentially, you need the money for some other reason, such as paying off a debt. You might incur penalty charges if you're unable to sell up on time.
You shouldn't be lending lots of your money if you'll definitely be needing all or most of it back early, before borrowers repay. That's on you, not the P2P lending company, even if it offers the ability to sell loans.
Mistakes related to not spreading money around enough (5-6)
As you'll see in the following two mistakes, it pays to:
- Spread your money across at least six P2P lending accounts and/or P2P IFISAs.
- Spread your money across many hundreds of loans, or even thousands.
5. Not lending in enough loans
Of the relatively few people who make an overall loss on P2P lending, one of the most common ways they do this to themselves is by not lending in enough loans. By doing this, you open yourself up to bad luck.
I'll give you one of 4thWay's standard, simplified examples. Let's say that you lend in one unsecured business loan. The loan has a 7% chance of turning bad at some point. 7% is quite low, but it's high enough that it could well happen to you. With these kinds of loans, there's a reasonably high chance that the entire balance of your loan will not be recovered. What if this happened to you and the bad debt occurred right near the beginning of the loan? You'll have lost all your money! 100% of it!
Now, what if you lent in 180 similar such loans? The chances of losing all your money now is something like 0.000000… with several hundred zeroes before getting to …0001%!
Indeed now, the chances of losing just 15% of your money is far less than 0.1%. And that's before taking into account any interest you earn on an annual basis to offset the one-off bad debts.
Losing money because you didn't lend in enough loans is bad luck that is entirely avoidable. And it's on the lender, not the P2P lending company, to ensure you are spread across enough loans.
6. Not lending through enough lending accounts
The point of any form of investing is that it comes with risks. If there were no risks, there would be no reward. No matter how good a P2P lending company is, or appears to be, you still have to spread across lots of accounts.
One of the most frightening things we know at 4thWay is that lenders typically spread their money across just two or three P2P lending accounts. This is completely insufficient. Even the specialists at 4thWay don't do this, and they have the skills, experience and resources to do extremely deep analysis and investigations into each P2P lending company.
Why do you think the 4thWay PLUS Ratings are based on you lending across at least six similarly-rated lending accounts? Any account, rated or not, might turn out to be unsatisfactory by itself. But there is very strong safety in numbers!
If you lend in just a couple of accounts, you need to blame yourself if you're disappointed with your future results. Certainly, that's the case now that you've read this!
Losing money through poor selection or de-selection (7-8)
It's never a good idea to rely on other people's reviews; you have to investigate the investment opportunity for yourself, understand it, and be sceptical.
I'll take you through the last two common mistakes in a second. But, so you know, you can typically avoid them if you:
- Patiently investigate each P2P lending provider thoroughly.
- Are prepared to reject them even after investing a lot of time into your research.
- Get to understand them well enough to still be very comfortable with them even in a substantial blip in their performance or when the economy turns south.
7. Ditching good lending accounts
We've seen that some lenders expect all their lending accounts to always give them substantial profits at all times.
P2P lending provides far more stable returns than the stock market, but that doesn't mean they don't vary at all. There will be better years and worse years.
Let's take a strong recession as an example. During such times, different types of people or businesses will be impacted in different ways, meaning that different borrowers will be impacted differently. And therefore different lending accounts will be too.
So you might ditch a good lending account, just because an economic downturn has hit its particular type of borrowers more severely on this occasion.
As an alternative example, maybe your current, specific batch of loans was unluckier than most.
The bottom line is, if you're not willing to accept underperformance in any of your lending accounts from time to time, you'll probably have none left in 20 years.
But the consequences are potentially worse than quitting P2P lending for no good reason.
You'll also reduce your diversification possibilities, if you sell up each time a lending account goes through a patch of underperformance. Increasing your risks.
You might double down on that by shifting your money to bad providers, because you've not had a poor experience with them yet. Perhaps you'll have read about other lenders' experiences, seen their positive reviews, and switch on that basis. That's not sufficient research, in the same way as it isn't when choosing shares or share funds.
Secondly, good times typically come straight after bad. When there have been more bad debts, this is when newer borrowers are assessed even more strictly and have to pay higher rates. The loans that follow tend to be more profitable than at any other time.
Furthermore, you'll reduce your diversification possibilities, increasing the risk of losses from not spreading your money around enough.
8. Losing money by not understanding basic features
Some marketing words or features seem to work like enchantment spells on some borrowers. High interest rates appeal to greed so much that lender scepticism is unduly lost.
The phrase “property-secured” seems to make people think of the indomitable UK property market and how it never fails to increase wealth. It's like they think those loans must be invincible, regardless of any details like how well those properties have been valued or what experience the people at the P2P lending company have in assessing these loans and preventing fraud.
The key fact here is that you can't be drawn in merely by headline ideas such as double-digit interest rates, real estate, or even self-flattering descriptions of how brilliant and experienced the founders are.
You've got to dig deep and remain sceptical. It amazes me that some P2P lending companies manage to draw in any lenders at all, when they don't even try to provide anything you might describe as evidence of their ability or track record.
Keep digging until you understand their results, how they go about their job and what the risks are in the loans you might be lending in.
Independent opinion: 4thWay will help you to identify your options and narrow down your choices. We suggest what you could do, but we won't tell you what to do or where to lend; the decision is yours. We are responsible for the accuracy and quality of the information we provide, but not for any decision you make based on it. The material is for general information and education purposes only.
We are not financial, legal or tax advisors, which means that we don't offer advice or recommendations based on your circumstances and goals.
The opinions expressed are those of the author(s) and not held by 4thWay. 4thWay is not regulated by ESMA or the FCA. All the specialists and researchers who conduct research and write articles for 4thWay are subject to 4thWay's Editorial Code of Practice. For more, please see 4thWay's terms and conditions.
The 4thWay® PLUS Ratings are calculations developed by professional risk modellers (someone who models risks for the banks), experienced investors and a debt specialist from one of the major consultancy firms. They measure the interest you earn against the risk of suffering losses from borrowers being unable to repay their loans in scenarios up to a serious recession and a major property crash. The ratings assume you spread your money across hundreds or thousands of loans, and continue lending until all your loans are repaid. They assume you lend across 6-12 rated P2P lending accounts or IFISAs, and measure your overall performance across all of them, not against individual performances.
The 4thWay PLUS Ratings are calculated using objective criteria that can be measured and improved on over time, although no rating system is perfect. Read more about the 4thWay® PLUS Ratings.