Is Peer-to-Peer Lending Safe For Lenders?
This page was last updated on 14 June, 2018
The process of money lending has been very profitable for thousands of years, even before computers and credit reports.
For many decades now, it has become especially easy to assess borrowers and decide what interest rates to charge them.
Research from Liberum and data from Trading Economics has shown that credit cards and personal loans in the US and the UK made money for banks every single year for 20 years, even making money during several recessions and property crashes that include the huge 2008 Great Recession.
Now, money lending as an investment has opened up to ordinary people like you and me through peer-to-peer lending accounts and their completely tax-free equivalents, P2P IFISAs.
The first 13 years of the peer-to-peer lending industry has started very well in the UK (and other developed countries), with very few people losing money overall. But lower risk is not no risk! Some people will experience losses. In particular:
- P2P lending will be subject to bubbles and crashes just like every other investment. While you can usually expect the volatility in lending money to be a lot less than the stock market, it is still important that you draw lines in the sand in advance to avoid being caught up in any euphoria and greed. (You can read more on this important risk in the article Greed and Fear in P2P Lending.)
- A significant number of those who choose to go for the higher-risk peer-to-peer lending options, rather than the safer options, will lose a lot of money during crashes.
- During extremely awful economic times – think as bad or worse than 2008-10 – even some of the safest P2P lending companies might not prevent every lender from making at least some temporary losses.
- The P2P lending sites have widely varying standards, abilities and experience in lending, whereby some do not even appear to conduct all the basic credit checks or other checks that you would expect or they do so with little skill. This means that the risks vary dramatically between them.
So the trick to safe lending is to educate yourself, and then keep your head and stick to sensible, safe lending strategies. Do this and you can expect to do just fine. Just like traditional banks used to do before they started offering mortgages to anyone who could sign a piece of paper!
What is the safest way?
Perhaps you want to do peer-to-peer lending safe in the knowledge that you're taking the lowest-risk route? There are some specialist P2P lending companies just for you.
The safest companies combine two to four of the following risk-reducing techniques:
- Lend your money to very low risk borrowers only.
- Allow you to spread your money across dozens or hundreds of borrowers. So you normally need an awful lot more than just bad luck to lose much money.
- Your loans secured against borrowers' properties, which means the P2P lending company could potentially sell a property and pay you back if one of your borrowers can't pay.
- A bad-debt provision fund: a pot of money set aside to pay you and other lenders back if one of your borrowers stops paying.
- Insurance to cover your losses if a borrower is unable to repay due to unemployment or accident.
Most importantly of all…
What all of the safer ones have, without exception, is plenty of relevant experience from traditional banking, including a good dose of experience in the specific types of loans that the P2P lending company is specialising in.
This will include underwriting (that's the process they use to assess whether a loan application should be accepted) and it will usually also include credit-risk specialists (who model the risks and help design and improve loan decision making).
How do the risks compare to savings accounts and the stock market?
We think you're far more likely to preserve and grow your wealth and savings with peer-to-peer lending than with savings accounts or cash ISAs.
Don't get us wrong: there are good reasons to save and use savings accounts. But it is virtually impossible for individuals to protect their savings against the ravages of rising prices (inflation) when using savings accounts and cash ISAs.
The stock market is also a fantastic investment when used in the right way. But P2P lending returns are far less variable than the stock market. Most stock-market investors lost money in 2014 and a heck of a lot of people lost money in 2008, and even in pretty good years there are a lot of individuals and even fund managers losing money on shares.
In contrast, lending, including peer-to-peer lending, has been much more stable and consistent, through good times and bad.
Again, it won't always be as stable as it has been in the past. But lending directly to borrowers provides far less variable returns to investors.
Peer-to-peer lending generally sits in between savings accounts and the stock market. The majority of people lending their money through P2P can expect to become wealthier, earning far higher returns than savings accounts and cash ISAs, but with less with risk than the stock market.
Is there a higher-risk, higher-return way?
While the safer P2P lending companies still offer much better rates than savings in banks, they are not necessarily stock-market-like returns. But, if you’re willing to take more risk, you can get far higher interest rates.
You can lend to payday loan borrowers, business start-ups or first-time property developers. These loans will go bad more often and so you must expect much higher interest rates to make the risks more worthwhile.
However, all of us at 4thWay® feel that the natural fit for most individual lenders is at the lower-risk end!
This was part two of our ten-page beginners’ guide
- Read part one: What is Peer-to-Peer Lending?
- Read part three: 4thWay's 10 P2P Investing Principles.
- See the contents of the whole guide.