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The Shortcomings Of Bad-Debt Provision Funds
It is sensible to plan for disaster and one way to do so is to set aside a pot of money to cover losses from bad debts.
Several P2P lending websites offer these bad-debt provision funds as part of their defences, such as:
These pots have ranged from as little as 0.6% of outstanding loans to an enormous 9%, although currently 1% to 4% is normal.
The main benefit of these pots of money is obvious, but, just to state the obvious, it's that it reduces the chances of you losing money with your own specific batch of loans that you're lending in. Many of these pots go further than that, in that they ensure that the risk of losses for all the loans is always spread across lenders, regardless of the loans that have officially been lending in. Some of these funds also sometimes help you withdraw all your money more quickly, because you don't necessarily have to wait for bad debts to be recovered from borrowers before you can get your loan money back.
But today I'm writing about the downsides, so let's get to those.
Smoothing costs money
Most of the time, the money for these pots comes from a slice of every deal between borrowers and lenders.
Part of the interest that the borrowers pay is diverted from your pocket to go to this central fund that you can't touch. You therefore receive lower interest rates in good times, but the impact of losses in the bad times is either eliminated or reduced. And even in good times, small losses will be covered by this pot of money.
This is similar to what share investors may know of as “smoothing”.
However, most people, most of the time, will never see the full benefit of these pots of money; when it comes to the time you want to stop lending and withdraw your money, the pot will probably still be there, but now it's for other people's benefit. Even though you helped fund it by accepting lower interest rates all along.
You also earn no interest on the money set aside, which is another sort of “cost”. (Unless you set up your own bad-debt provision fund. Read about that in A Reserve Fund For Funding Circle Lenders.)
The cost of smoothing can be high, as shown in the pensions industry. Smoothing pension investment returns was very popular in the 80s and 90s, but the costs were so high that investment returns were very disappointing. These sorts of pensions are now rare in the UK.
That said, smoothing stable lending returns on low-risk loans is easier and therefore cheaper than smoothing the returns of a rocky and often violent stock market, because you don't need to divert so much of the profits to a reserve pot. Indeed, banks often do something similar and yet they have made very decent returns on money lending for a very long time.
Too much of a comfort blanket
Bad-debt provision funds are not guaranteed to cover all losses. Some of these pots, perhaps even most of them, will probably be breached during a really bad economy, such as one equivalent to the 2008-10 financial crisis.
They will still be useful even if breached. They'll take the brunt of the impact. Provided you have been using simple, sensible, safe lending strategies, the interest you earn will cover any further losses.
However, if you go into this by believing that a bad-debt provision fund will always cover all losses, you're going to get a shock if it doesn't. You're likely to panic and do precisely the wrong thing.
That would probably include panic-selling your loan parts. When lots of lenders panic sell at once, the only way to convince others to buy your loan parts off you is to sell them for less than you put in, e.g. you get back £900 for every £1,000 you lent. So you make your losses happen yourself. That's if you're able to sell at such a time.
What you should do, if you've been lending sensibly, is the reverse. Provided the P2P lending websites are still approving high quality loans then it makes sense to take the losses on the chin and keep lending regularly, so that you are buying loan parts for £900 instead of £1,000, rather than selling them.
When reserve funds make the most sense
Whether you prefer P2P lending websites with bad-debt provision funds is a personal choice, although I hope you understand both the pros and cons better after this article.
I just want to add one more point.
If you lend on a monthly basis then, by having a bad-debt provision fund, you're effectively doubling up on smoothing, since you already smooth naturally by buying loan parts during good times and bad. It should even out nicely in the long run.
So perhaps bad-debt provision funds make the most sense if you don't lend regularly.
This piece has been updated in 2020 to reflect the latest statistics and P2P lending websites appropriate for today, but it was otherwise written in 2017.
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