The Impact Of Inflation On P2P Lending Results
The UK annual inflation rate has risen to 3%, after dropping below the 20-year average of 2% (or, rather, 1.999%) for 21 months in a row up to April 2021.
With many countries have recently seen rising inflation, and with nearby Germany recently reporting a 4.1% annual increase in prices, I thought now was a good time to address the impact of inflation on P2P lending.
I'll be using the CPIH measure of inflation throughout, as it's probably the most accurate. Not just because of the method used in calculating it, but because includes homeowner costs in the measure of consumer prices.
When inflation is most destructive for lenders and investors
Inflation tends to be worst for investment returns when the annual rate of inflation is growing rapidly. So it's not usually high inflation itself, but the fact that the inflation rate is currently rising fast.
Let me give you a hypothetical example. If the inflation rate plateaus at 10%, that's a very high rate of inflation. But, while it's sitting around that rate, it's not usually so bad compared to the period before.
In the period before, let's say that inflation went up rapidly from 2% to 9% in a matter of a year or two. It's during that time that investments are usually most hit by the surprise of rising prices. And that's even though the inflation rate was actually lower then.
So it's the explosion in the rate where it is worst.
The reason for this appears to be adjustments made by investors when they assume even higher inflation is to come, and demand better rewards for the future risks.
In lending terms, it means that lenders will often only continue to re-lend the payments they receive from borrowers if the new borrowers are willing to pay substantially higher rates.
On the flip side, when the growth in the inflation rate slows down, and as it starts to reverse, this is when investors tend to get the best returns, after accounting for inflation.
History lesson from the banks
Let's look at some real examples.
Banks often have to deal with rising inflation. Data from Liberum and the Office for National Statistics shows that banks turned a profit on credit-card lending after both bad debts and inflation in all but one year between 1999 and 2015.
For bank personal loans in the 21 years from 1995 onwards, there were just three years where the net lending result lost to inflation.
Unfortunately, I have no solid data on the overall performance of personal loans in the years prior to 1995, which was when inflation was very high. However, in the six years following that, as the high inflation rates had plummeted to around 2.5%, the banks made extremely impressive returns of between 9% and 14% every year for six years. Again, that's after bad debts.
That's an example of how intensely profitable money lending can be, after the initial shock of high inflation.
History lesson from Zopa
Zopa was the only P2P lending company in the UK when inflation shot up to 3.5% in 2008. In 2008, after taxes, the average lender paying higher-rate tax might have just lost to inflation that year. Most lenders still made a profit while taking inflation into account, even though the higher inflation at the time coincided with the Great Recession, and therefore more bad debts.
In the two following years of 2009 and 2010, Zopa lenders had some of their best ever results versus inflation. On average they were earning 6% to 7% after bad debt in both years, while inflation averaged 2% to 2.5%.
Average inflation across the three years of 2008 to 2010 was 2.9%. So, despite lending through a terrible recession and its aftermath, as well as a sharp rise in inflation, Zopa lenders across the period made decent returns.
Indeed, since 2005, we can easily say that P2P lending has comfortably beaten inflation and bad debts after costs in any three-year period, even for higher-rate taxpayers.
How's it looking today?
Inflation has averaged 1.7% over the past two years. If it were to rise now to 4.1% for a whole year, like in Germany, the average inflation over three years would just be 2.5%. That's not worth getting upset about.
We're currently still well within ranges of inflation that most people would consider “normal”, at least in terms of investing. (Savings accounts, with their always pitiful interest rates, are another matter, as they continue to be devalued, as usual, just at a faster pace.)
What about much higher inflation?
Having once kept a multi-decade database of leading economists' historical forecasts into inflation, gold prices, house prices and many more, I learned that not a single forecaster is reliable enough for us to base any money decisions on their soothsayings. Not even close, in fact.
Most of the time, it's simply not possible to know what's going to happen. But what we do know is that higher inflation does happen from time to time, so you have to accept this as a possibility…
What to do about inflation?
So what do we do to protect ourselves from inflation and especially high inflation?
I once read a journalist say something along the lines of: “House-price predictions are completely unreliable, but it's all we've got to go on, so here are the latest forecasts…”
I think we can base our lending and investing decisions on a more rational approach than that.
Money lending is not as much of a long-term commitment as the stock market, by any means, but it's still something of a commitment. You need to be prepared to tie yourself in for some years, if necessary.
The best investors have always acknowledged the natural life or horizons of their chosen investments in this way, and been prepared to hold on patiently. You simply find high-quality investments and stick with them. I recommend you do the same with P2P lending.
In order to benefit from the greater returns in the years after any rapid rise in inflation, you continue to re-lend payments and interest received by borrowers. Lending rates will typically, eventually, be pushed upwards by inflation to compensate. So your new lending will become more profitable again.
What about low-rate, low-risk lending?
I think low-rate lending is a special case – provided the low rates are justified by low risks. (I'm thinking of when Wellesley & Co changed its P2P lending rates to a ludicrously low one-point-something percent! Before it thankfully pulled out of P2P lending and switched to another model. I understand it's now in great difficulty.)
Let's take the incredibly solid Loanpad* as an example of low-rate, low risk. This is a lending company that is likely to reliably pay you the targeted lending rate, or something extremely close to it, even in very, very difficult economies.
Even though it's been offering one of the lowest rates available, its Premium account has still paid out inflation-beating returns to all lenders since the beginning.
This has changed in the past couple of months for some people not lending through its tax-free IFISA, because its 4% rate has not quite been sufficient to compensate higher-rate taxpayers for all the inflation, when looking at rising prices for the past year.
But with Loanpad being such a solid holding that will see you through most times with a safe, inflation-beating return, it makes no sense to give up on such a quality investment, as one of your many P2P lending accounts in a diversified portfolio. A much better way to look at it is that all lenders have made a profit after inflation over the past three years.
It's not about beating inflation every year
One final point I'd like to make. If you think you need to beat inflation every single calendar year with your money pot, you're setting yourself up to lose.
Worse than that, the search for such an elusive goal as that can make you do very crazy, risky things. Accept that sometimes it happens and think of your poor fellows who lose money every year by just keeping all their money in savings accounts. They will lose even worse whenever inflation rises rapidly.
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