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The 12 Key Peer-To-Peer Lending Risks
The main peer-to-peer lending risks are:
- Yourself (psychological risk).
- Not enough diversification (concentration risk).
- Losing money due to bad debts (credit risk).
- Losing money due to a P2P lending site going bust (platform risk).
- Losing money due to a solvent wind down (more platform risk).
- Losing money due to fraud or negligence.
- Selling into a loss (crystallising losses).
- Losses because you can't sell early (losses from liquidity risk).
- Lost capacity to earn from unlent money (cash drag).
- Reduced real earnings due to inflation (inflation risk).
- Reduced earnings due to legal or tax changes.
- Losing money from foreign currency fluctuations (currency risk).
Introduction: how big are the risks of peer-to-peer lending?
From 2005 until mid- 2023, the P2P lending industry has shown individual lenders just how stable and resilient it is. Easily surviving the Great Recession/financial crisis of 2008 and offering remarkably sturdy returns after the 1-in-300-year pandemic recession of 2020 and on through the ongoing lockdowns in 2021.
Even so, despite our best efforts across many pages and research articles, and well over 100 citations in the major national press, not quite all 4thWay users have been prepared for some of the inevitable peer-to-peer lending risks.
The key information you need to deal with the risks has always been in this guide you're reading now, since 4thWay started in 2014. But we've sometimes updated it with additional information.
We want to continue to help more 4thWay users understand and manage P2P lending risks.
Please allow us to really ram home to you what the risks in P2P lending are all about, and how to minimise them. This will help you be confident in your lending strategy and ensure you don't react the wrong way during disasters!
The 12 categories of P2P lending risk
The key peer-to-peer lending risks that might actually lead to losing money can be placed into 12 different categories. Here is a list in priority order and some simple but highly effective ways to minimise those risks.
P2P lending risk 1: yourself (psychological risk)
When you ask “How risky is peer-to-peer lending?”, the answer often comes down to how much you step back, calm down, and look at the facts, when making lending decisions. Good investing is usually fairly simple, so any problems are usually down to our own behaviour, attitude and temperament.
So, the biggest risk in peer-to-peer lending – as with every kind of investment since forever – has always been what happens in our own noggins: we get greedy when we should be cautious; we're afraid when we should be confident. We convince ourselves we know everything, when we don't.
We call all this “psychological risk”.
Greed is the big one and we've seen this to be the case in P2P lending already. You observe that you could earn a highly attractive lending interest rate and you want it so badly that you'll do anything to convince yourself the investment is a safe bet.
Sometimes you really can earn exceptionally high interest rates with well-contained risks, but this is not usually the case.
In a P2P lending context, being greedy usually means putting all your P2P investing pot into just one or two lending accounts that advertise high lending rates. Often, you do so without much thought or research.
Too clever by half
In share investing, the vast majority of people who actively try to pick and choose investments, buying and selling frequently to get an edge to boost their returns – they actually do substantially worse than others who invest more passively from a distance.
We should certainly expect the same to be happening in P2P lending, although to a much lesser extent. That's because prices are often fixed for buying and selling, and there's a lot less reason to trade regularly.
It's still one of the psychological risks of peer-to-peer lending though. For example, it's easy to get overconfident and select just a handful of high-paying loans to pile your money into.
It doesn't help that nationally renowned money and investing experts have recommended “dipping your toe in” as a way to get to see if a P2P lending account is any good. The dip-your-toe-in technique is a ridiculous way to ascertain whether an investment has the right risk-reward balance for you. Just because it doesn't go wrong in the first few months, it doesn't mean it won't later on.
Dipping your toe in teaches you nothing about the fundamental risks or whether the interest rates cover those risks.
Overestimating your knowledge is a big psychological danger. That little knowledge, as the saying rightly goes, can be dangerous. You're overconfident that things will be plain sailing.
That applies to people a lot smarter than me. I've seen engineers, mathematicians and accountants lose serious amounts of money when investing. Mostly in shares, but actually in a variety of investments.
I even know a professional investment journalist who lost everything, because he didn't follow his own excellent advice, got greedy, and put all his money into a single, losing big bet. Don't presume that you're smart enough to break all the rules!
Following a crowd's euphoria
It always goes wrong at the point where the last sceptic is saying: “This time, it's different; the stock market has gone up and up and up, and this time there will be no crash.” That's when everything invariably collapses on all the people who got greedy, leaving sensible lenders and investors to make a big profit from what's left.
It doesn't happen to all investments at the same time. In the P2P world, for example, most P2P lending companies will maintain good standards.
But some P2P companies will lose their heads and their discipline, slackening their lending standards and accepting borrowers at even lower interest rates, because “nothing has gone wrong before” and because the management at some of those businesses believe they have to keep growing beyond reason to earn their bonuses.
You can be sure that not all P2P lending companies will remain immune to this, so it's a risk in peer-to-peer lending.
We've seen it many times before in other industries, most recently in the sub-prime property bubble of 2008.
The problem was that banks thought: “We haven't lost money lending to borrowers with a fat 20% deposit, so let's make it 15%. Then 10%. Then 5%. Now 0%… Actually, we can lend more than the property is worth! And we can do so when the two incomes of the homeowners are stretched really, really thinly. Because nothing's gone wrong before…”CRASH!
Nothing went wrong before because they kept sensible standards. Always demand the same of the P2P lending companies you use.
This is not about the inevitable worsening returns that even good platforms will sometimes pay you during recessions and property crashes. I'm talking about the larger issues caused by lending to more and more borrowers of increasingly poor quality, without compensating enough for the risks.
Don't get sucked into craziness like this. Be on the alert.
In a downturn, some types of lending might suffer reduced results, with a diversified portfolio getting lower gains in the period. In an absolute and total catastrophe like almost no other, it's even possible to suffer a loss in some quality P2P lending accounts.
Lenders who don't deeply understand that different downturns can impact different types of lending and reduce their returns a lot, and that this is normal, might be angry and sell, missing the opportunity to earn the best returns when the recovery happens.
You might even be forced to sell at a cut price if you want to get out with the crowd. Fear is a real risk in P2P lending.
“I'm soooo right! Because…”
Once you've put a lot of effort into researching an investment, you really don't want to reject it. This is called confirmation bias. By really wanting to believe in an investment, you look for reasons to buy it, when a good investor should be looking for reasons not to buy.
Some P2P lending companies are big on sales talk, but offer very little in terms of information, data and evidence to show how good they are. Don't ignore warning signs such as this. On the contrary: seek them out!
Summary of how to avoid psychological risk in peer-to-peer lending
All peer-to-peer lending risks have very simple ways to counter them or minimise them:
- The key way to prevent your emotions secretly nudging your decisions is to just lend in P2P lending opportunities that pass all your criteria in a checklist. You could do very well at preventing all of the risks of peer-to-peer lending if you use 4thWay's 10 P2P Investing Principles.
- Stick to your lending rules through thick and thin – even if some P2P lending sites themselves don't do so.
- You need to start from a sceptical point of view and ask a lot of questions. Try to destroy the idea that you should lend through a particular P2P lending account, rather than looking for reasons to lend. If you can't destroy it, you've probably found a very good one.
- For the bulk your investing pot, stick to reasonably ordinary types of loans, and lots of them, and lots of different types of loans to cushion you against various different economic situations. You'll feel safer and will be less likely to make poor decisions later on.
- Commit in advance to spread your money widely across lots of loans and lending platforms and invest regularly without trying to get that extra 1%.
- It would be a clear over-reaction to stop lending through a successful P2P lending company just because it supplies you with much reduced returns for a year or two after a major recession strikes. Sometimes, things like that happen. If you hang on, you'll continue to earn more interest on your good loans that offset bad debts further.
- If you quit money lending altogether when it has provided such startlingly stable returns overall, that would be even more tragic. Like the stock-market investors who aren't prepared for the fact that it sometimes has massive down years: they sell at the bottom and are not tempted back in until when it's already risen too high again. Don't be like that.
- Earn deserved confidence to prevent your emotions taking over. You don't earn this confidence by getting good results for a year or two. You do so by learning about P2P lending – and keep learning to pile up your knowledge.
- The crowd can be useful in ascertaining how easy it is to use a specific lending account, how easy it usually is to keep your money lent out, and in gathering ideas on how to assess individual loans. Their input is valuable, but they don't replace your own assessment when it comes to finding the risk-reward balance and whether the investment is actually any good. Think independently, ignore euphoric or doommongering talk – and don't follow the crowd into disaster.
- Set some of your own standards that are easy to follow.
To expand on that last bullet, for example, for property lending you might set simple standards for the loans you lend in, like:
- Just lend in loans against properties that are valued at 2 times the loan amount.
- Or just lend against properties that are being rented out by experienced landlords.
- Every loan to landlords must be less than 80% of the property value.
- The rent the landlord is receiving must be at least 1.25 times the total loan (mortgage) repayment on every loan.
- Lending interest rates need to be several percentage points above the best savings rates.
Accept no imitations!
The list of 12 risks continues below. Please allow me a brief interlude, because it's come to our attention that large parts of this page have been copied by other websites. Those websites sometimes end up ranking higher than us in google search results with our content!
4thWay is a frequent target of plagiarism, because our specialists with serious, diverse backgrounds lead the field of P2P lending with high-quality, 100% original research, including interrogations and data analytics. It costs a lot of time and money to do what we do.
Plagiarism is often only partial, so that copyright thieves can better cover their tracks, but this means that they leave out important facts or re-write our material inaccurately. That puts risks on you as lenders as well.
P2P lending risk 2: not enough diversification (concentration risk)
If you lend to one borrower, it might not matter how brilliant the P2P lending site is at assessing loan applications, you could get unlucky and lose lots of money. This is called “concentration risk”, although I'd probably also call it “rookie mistake number 1”.
Avoid concentration risk of peer-to-peer lending with lots of loans
Across your entire portfolio of P2P lending accounts, you must spread your money across lots of loans. This is the absolute central pillar in good peer-to-peer lending risk management.
The impact of breaking your money into small parts like that is simply incredible. Spreading your money across dozens of prime property loans, or hundreds of small personal or business loans, reduces the risk of suffering severe losses from bad debts to a minuscule fraction of the risk compared to lending to just one borrower.
We're not kidding. The maths is mind boggling how the risk shrinks when spreading your money around. 4thWay's most senior risk specialist has helped build many datasets from banks and P2P lending companies over 30 years that demonstrate this, 4thWay has collected a lot of data showing it remains true in P2P lending, and public records also show how stable money lending can be with lots of loans.
The more secure and solid the type of lending, the fewer loans you need, but you always need to diversify.
Another absolutely essential way to avoid concentration risk
You should also spread your money across several peer-to-peer lending sites. This doesn't just reduce the risk of suffering losses from bad debts; it also reduces all other peer-to-peer lending risks.
(If you use IFISAs, here's how you can still spread and reduce your risks in IFISAs quickly, even though you're restricted in the number of IFISAs you can open.)
Don't concentrate all your money on the bad debts
Hand in hand with spreading your money widely is the amount of time you lend for. By holding your loans until they're all repaid, you earn all the interest you can out of your good loans, while allowing time for some of the bad debts you suffer to be recovered.
Some (but not all) kinds of P2P lending typically see the bad loans reveal themselves early on. So, within a few months, a good chunk of all the loans that will ever go bad, have already done so. But, at this point, you haven't yet had much time to earn interest. That's why, for these kinds of loans, the first few months can give you your worst results for the whole time you're lending to your borrowers.
If you're unaware that this should be happening, your reflex can be to sell all your loans in disappointment. This means you've sold all the good loans you had, even though they would have earned you interest for years to come. The risk is that you've left yourself with bad debts and whatever can be recovered from those bad debts.
In other words, you've concentrated your lending portfolio on all the rubbish borrowers you were dealt! Don't make this mistake. Understand the profile and characteristics of the loans you're getting into before you start lending, so that you're not shocked.
P2P lending risk 3: losing money due to bad debts (credit risk)
The most “commonplace” reason for losing money on some loans is when your borrowers aren't good enough or they suffer misfortunes. When they can't pay back all your money, this is called “credit risk”.
A P2P lending company might recover or partially recover a bad debt, as well as interest due to you. Any bad debt amounts that aren't recovered are called by lots of names: a loss, crystallised loss, credit loss, write off or charge off.
Of all the peer-to-peer lending risks that we face, this is the one which 4thWay spends the most time assessing, as it comes down to the basic competence of the people behind the P2P lending companies, their P2P lending risk management, and the results of the loans.
10 years' experience in assessing these providers also shows us that good lending practices usually translate into good management across the board, which lowers many other risks in this list, too.
There's a lot that goes into good peer-to-peer lending risk management. P2P lending companies have varying degrees of skill and experience, and the quality of their processes vary.
They need to be conducting the appropriate checks (such as credit checks or physical inspections of properties from an independent surveyor). If they're deliberately arranging higher-risk loans, they need to be setting interest rates higher to reflect that. They need to be carefully managing any possible conflicts of interest.
When loans go bad, you generally expect that the interest you earn from your good loans is enough to cover any losses.
Sometimes you have additional protections too. The loans might for example be secured on the borrowers' property, which can usually now be repossessed and sold. Or the P2P lending site might have a pot of money set aside to pay expected bad debts.
If enough loans go bad though it could, in extreme cases, or at weaker peer-to-peer lending offerings, overwhelm all these defences. You might be left with a loss. During recessions or other financial crises, the risk of suffering losses in one or more of your lending accounts goes up.
Bad debts are a certainty, but a little effort from you ensures they are highly manageable
When you talk about “risk”, it means something bad that might happen. Bad debts are not a P2P lending risk, because you're certain to suffer some bad debts, some of the time. Accept the fact that they will happen.
What's important is that you're not at all certain to make an overall loss. Indeed, you're exceptionally likely to earn an overall profit if you follow simple lending strategies. Those strategies minimise bad debts and make them less volatile.
The risk of making an overall loss or a large loss in money lending is substantially lower than the stock market.
How to minimise credit risk in peer-to-peer lending
- Many peer-to-peer lending risks are minimised by spreading your money widely across hundreds of loans and many P2P lending accounts. This is especially true for credit risk. I'll give you a simplified example: if one-in-20 loans typically turns bad, and you lend in 200 such loans, you have just a 0.1% chance of suffering twice the typical bad debts, i.e. suffering two bad debts in every 20 loans. However, if you lend in just 20 such loans, the chance of suffering at least twice the typical bad debts rises to 26%!
- As mentioned earlier, you also need to keep lending until your good loans are repaid in full with interest, and allow time for any recoveries to be made on bad debts.
- Ensure that your money is also spread across different kinds of loans and borrowers, because each downturn has different impacts on the various types of borrower or loan. You don't want all your money in the hardest hit area.
- The rest comes down to selecting high-quality P2P lending accounts. You could start using the P2P lending reviews in our comparison tables and by learning more about assessing P2P lending accounts in 4thWay's guides.
P2P lending risk 4: losing money due to a P2P lending site going bust (platform risk)
We're now getting into lesser risks in peer-to-peer lending, in that they will impact far fewer people, although individuals could still sometimes lose a good chunk of the money they lent in these cases.
This next one is about the risk of losses due to peer-to-peer lending sites and IFISA providers going bust.
If one of the P2P lending sites that you use collapses, there's also a substantial risk that you may experience delays in getting your money back.
All of this is called “platform risk”.
Although there are bound to be a few real disasters, the risk that you won't get all your money back due to the provider going out of business is actually relatively small, for three big reasons:
Ring-fenced loans are still owed to you
Dozens of legitimate P2P lending sites have gone out of business already. That is normal for a relatively new industry that is still bedding in. Many of these P2P sites were small and never really got off the ground, but the rest had started matching borrowers and lenders together.
So far, most of these companies closed with individual lenders making a profit. The prime reason for this is a direct relationship between borrowers and lenders: the P2P lending site is just an agent in the middle. You have been lending directly to each borrower, and each of them still owes you your money and needs to keep meeting repayments.
Direct lending like this means that the P2P lending site's own debts should be ring-fenced. So, if the P2P lending site goes bust while owing money to Barclays Bank, Barclays can't elbow in and take over the loans that you're owed.
That is your first line of defence against the risk of losses from peer-to-peer platforms gently closing down. And it's a very good one.
The P2P lending company needs to earn your trust by ensuring the lending is direct in practice as well as on paper, because a legal opinion provided to 4thWay is that it might not always be sufficient to merely have contracts defining the direct lending. The background processes are important too.
Signs to watch for at P2P lending companies are good all-round governance, being on the ball with regulatory changes, filing company accounts punctually, and very good admin when it comes to running your account. If they are taking these things seriously, they're probably taking the rest seriously, too. If they have a named, in-house lawyer who has specialised in regulatory compliance, that is a nice plus.
UK P2P sites are required to have funded wind-down plans
In another substantial line of defence, P2P lending sites authorised in the UK are required to have wind-down plans that are fully funded. The FCA is committed to strengthening this further over time.
P2P lending sites must provide lenders with information about these plans, so you know exactly what will happen to your money.
If the wind-down plans are reasonable, a P2P lending site should be able to continue to administer and wind-down existing loans smoothly, repaying you your money until all the loans are cleared.
The costs of winding down a loan book are usually relatively small, since it largely means just administering loans until they are fully repaid.
Some of the big costs in P2P lending are the advertising costs to attract borrowers and lenders, as well as the process of assessing borrowers to see if they're worthy of a loan. You can expect both these costs to disappear instantly on a P2P lending site going into “wind-down” mode.
While smaller operations are – perhaps – at greater risk of not surviving for the long run, their costs are even lower. In this case, the founders will often be able to wind down their small loan books themselves in their spare time.
Most P2P lending sites in the UK are required to have at least £50,000 in cash set aside to fund the wind down, even after they have been taken over by bankruptcy administrators. The amount a P2P site needs to set aside is even higher if a lot of money is lent through it.
Administrators will also take over any fees and interest that the P2P site itself was due to earn, and can use those fees to fund itself while winding down your loans.
Currently, just one P2P lending provider (Kuflink* | Kuflink Review) has provided every single piece of information and data we want on wind-down plans. But 4thWay is steadily receiving increasing information from others and so we're pushing for full transparency from all of them. For the latest status, read What Do We Make Of The P2P Lending Companies' Wind-Down Plans?
The interest you earn provides additional protection
If it turns out that none of those above safeguards are sufficient and that funding is a bit short, the administrators might shave off some of the interest that lenders were due to receive on loan repayments.
In an ordinary wind-down of a well-functioning lending platform, any additional costs will usually remain low enough that lenders continue to make positive returns on their loans as they are repaid. This sufficiently covers any remaining risk of P2P lending losses.
If the costs of running down the loans spiral beyond even that, lenders might finally lose some of the money they lent. This would be a most unusual and extraordinary situation though, as it's not credible that lending accounts with reasonable loans would require such high administration fees and expenses.
Lenders who have been lending for a year or two before the P2P lending site closes down will already have earned very substantial additional protection against losses in this case.
Some special circumstances during a wind-down might increase the chance of losses on individual loans
There will be the occasional issue specific to the P2P lending company that is closing down.
For example, if lenders have been funding developments in tranches, an ongoing development might suddenly be unable to raise the remaining money needed and the project might be delayed. Existing loans might be delayed and there is an increased risk that the development site can't be completed or sold to cover all the previous loan costs.
To further reduce your risk of losing money from a bust P2P lending site
- Look out for reports that the P2P site appears to be either profitable, well funded, well backed by investors or a parent company, or cheap and simple to run.
- If you're familiar with company accounts, there can be indicative nuggets or even solid reassurance in those, even in the case of private businesses, which put less information in their accounts than public (stock-market) companies.
- Look for peer-to-peer lending sites that are regulated by the UK's Financial Conduct Authority, as these are required to have the fully-funded wind-down plans.
- Take steps to work out if the lending site really does do direct lending. Some websites that describe themselves as P2P do not actually offer direct, ring-fenced lending, but 4thWay only lists sites that appear to offer that kind of genuine, “pure” P2P.
- Lend across several different P2P lending sites. If one out of five of the P2P lending companies you use both goes bust and – very unfortunately – just returns 90p in the pound, that works out at just a 2% loss across all five platforms. Lending interest you earn across all your lending accounts will easily cover those losses.
We must expect that there will be the occasional bad egg that collapses and does worse for lenders than expected. However, that's most likely to happen when the collapse is also combined with other risks lower down this list.
P2P lending risk 5: losing money due to a solvent wind down (more platform risk)
Companies that have chosen to close their P2P lending operations over the years have done so for a variety of reasons. These reasons have included:
- They have sold their businesses to banks, which have taken on their borrowers and teams, but have no use for P2P operations.
- The owners and directors decided their lending niche was too difficult to sustain or grow for the long run, so closed before things got difficult.
- The structure of their lending accounts were inhibiting them from living up to all lenders' expectations, perhaps because of over-optimistic claims about the chances lenders have of being able to sell their loans early.
- A strategic decision was made to shift to non-P2P lending. (Many P2P lending companies are born from non-P2P lending business that shifted into P2P, too!)
These businesses have had no issues paying their bills, so they are solvent rather than insolvent. That means they haven't gone bust.
On closing, all of them so far have repaid lenders all the money that was owed to them. Plus, almost all of the interest after bad debts that was due to lenders as well.
Indeed, they have often repaid lenders early.
Occasionally, in these cases, lenders have seen somewhat reduced lending returns in those closing months or years, but that has primarily been due to bad debts, which is covered in a previous risk in this list.
However, in one case that is still ongoing, a P2P lending company has told lenders that they can expect additional fees. The potential scale of those fees might seriously reduce the interest they earn on their final loans.
That P2P lending company still expects lenders to make overall positive returns on those loans, and the last dataset we received from them does support that scenario. However, a large increase in fees makes it more likely that lenders will suffer losses, because you have less interest cover.
And that's besides the annoyance of suddenly being hit by those fees. The reason given for the fees and the wind down was that the business wanted to switch to a different lending model.
Thus, a strategic shift away from being a P2P lending company can potentially lead to greater risk of losses, even if the business is otherwise very sound and loans are performing roughly as expected.
Reducing risk of losing money in a solvent wind-down
You could look to signs of great character at the P2P lending companies. Its easy for us to say, since we have direct access to key people and interview them, but there's quite a lot you can do from home and often it's the arm's length research that helps get a clearer picturer.
Hone your antennae regarding so-called “moral hazard”, which are signs that the people operating the businesses are less likely to take the hit of higher costs in a solvent wind down themselves.
Signs of moral hazard can include reading stories, articles and blogs about or by these P2P lending companies that too often have a big emphasis on their business' own revenue growth or funds it's raised from its shareholders, which can potentially indicate a lot more interest in getting rich than in helping small investors and lenders.
Another potential sign is extremely rapid growth in the lending volumes or a constant shift in the types of loans available, as the provider potentially agrees to loans outside its experience to earn fees.
You can also look to the volume and type of decisions made against the P2P lending company by the Financial Ombudsman Service here.
No sign of moral hazard is conclusive by any means, but, the more you see, the less you might want to put into such a P2P lending company.
Assessing moral hazard is not easy for individual lenders, especially as you don't usually have a direct line to the senior people who run these P2P lending companies. So you should follow more of the other suggestions to lower risks found throughout this page.
You might be interested in Which P2P Lending Companies Have Good Character?
P2P lending risk 6: losing money due to fraud or negligence
All types of saving product or investment, from the stock market to property to savings accounts and beyond, attract some fraudsters or even people who commit criminal (or near-criminal) negligence. P2P lending in the UK will be no different.
In the UK, while fraud and serious negligence will occur far less often than P2P lending sites going bust, the losses you'll make if you're sucked in by scammers or chancers are likely to be much bigger.
Most P2P lending businesses would rather go out of business gently than commit fraud or gross negligence to survive, and this has been demonstrated many times already.
But, when it does happen, the consequences are likely to be more severe on your wallet than any other risk mentioned so far.
As with reducing bad debts, it's down to the companies to ensure they have effective peer-to-peer lending risk management and good governance.
How to avoid fraud risk in peer-to-peer lending
There are usually many tell-tale signs to look out for, making this risk easy to dodge, almost all of the time. The more of the following you spot, the more likely it is that you're being targeted as a potential victim:
- No entry on the Financial Conduct Authority's register. (Read How To Check The Financial Services Register For Monsters.)
- Not showing on prominent websites such as 4thWay.
- Poor quality website.
- Poor English on the website and materials.
- No opportunity to contact them by telephone.
- Claiming to be expert while not revealing much information about what they're doing.
- Highly aggressive marketing language, i.e. talking down the risks while talking up some glittering rewards.
- (If you can read company accounts) lots of question marks about their business or finances, including small companies making losses while paying very high director salaries.
Read The Peer-To-Peer Lending Fraud Checklist for many more signs to look out for. In addition, follow 4thWay's 10 P2P Investing Principles to seriously reduce the chances of being hit by any of the 12 P2P risks.
How the FCA lowers fraud, negligence and other P2P lending risks
The FCA does a lot of work to screen out applications to run a P2P lending company. Most of the applications don't fail because of malign intentions, but for other reasons.
Still, to an extent, the FCA's application process keeps out fraudulent P2P lending companies. To a greater extent, it also reduces (but doesn't eliminate) the number of P2P lending companies that launch and go on to be negligent or highly incompetent:
Click to enlarge.
P2P lending risk 7: selling into a loss (crystallising losses)
If you need to sell very shortly after you start lending and you have outstanding bad debts in your portfolio of loans, you might turn a paper (and usually temporary) loss into an actual one. This is called “crystallising losses”.
This peer-to-peer lending risk doesn't occur all that often, but it's more likely with some kinds of lending than others.
For example, if you're lending in typical bank-like loans to businesses or individuals, it's not unusual for a proportion of borrowers to quickly get into trouble. This is to be expected and it's part of what is called the default curve – the times at which loans typically turn bad.
The risk is higher if you combine it with peer-to-peer lending risk 1, psychological risk – if you panic during a severe recession perhaps. Losses climb in a recession, but if you haven't been lending long enough to earn interest, you'll sell all your good loans leaving only the bad debts outstanding.
Thus, unless a very high level of those bad debts is ultimately recovered, you could easily have helped yourself lose money.
Some P2P lending companies also charge early exit fees if you sell before borrowers repay, which would likely add insult to self-injury.
How to avoid the risk of crystallising peer-to-peer lending losses
Only lend when you're highly confident you're willing to do so for many years.
Only lend when you're highly confident in your chosen investments.
When selecting P2P lending companies, try to get a few in the mix with high-quality property loans, which are usually repaid in full within one to three years. These include lending to borrowers against their rental properties and prime development lending to experienced developers.
Property bridging loans and lower quality development loans often pay highly attractive interest rates, but lots of loans turn bad and there can be quite a wait to find out how much will be recovered.
Also, when choosing lending accounts, choose some that don't allow you to sell your loans at a lower price. This enforces discipline on you; you'll either have to wait until another lender is willing to buy your loans from you at the full price, or you'll wait until borrowers repay in full – with interest.
When there are exit fees, they are between 0.2% and 2.5%. You usually just need to lend for a month or two to earn enough to pay for the exit fee.
P2P lending risk 8: losses because you can't sell early (liquidity risk)
The ability to sell your loans early – before your borrowers repay them naturally – is not a promise or a sure thing. It's just something that you might be able to do.
Most P2P lending websites offer the ability to sell your loans early and most of the time it works out reasonably well, but it's far from a guarantee. Selling early doesn't always work out. This is called “liquidity risk”.
This is an inherent quality of money lending that you absolutely need to fully understand before you get started. There's no point getting angry with P2P lending platforms that become illiquid for a time, because it's part-and-parcel of this form of investment.
When you can't sell, your loans still accrue interest and the borrowers repay eventually, so it's not the end of the world.
But it could be a disaster if you'd lent your money hoping to take it out again just a few months later for a deposit on a house. You might find that you lose money by not being able to buy at the right time. That is one of the hidden risks in P2P lending, in that the loss occurs not because your loans did badly, but because of a missed opportunity somewhere else.
Or you might not be able to pay a bill and the penalties outweigh the interest you're earning in P2P loans. Or you have to borrow money at higher interest rates while you wait for your P2P funds to come back to you.
There will be other scenarios where financial obligations mean you need your money back in your bank account and it becomes costly for you, because you're unable to get it on time. Lending the money you're saving to pay your upcoming tax bill is not such a good idea.
How to avoid liquidity risks of peer-to-peer lending
Be deeply aware of when you'll need the money you intend to lend. The more money you'll need in the near future, the less you should put into investments, such as P2P lending.
The natural horizon for these investments is usually until the borrowers repay and all possible recoveries of any bad debts have come in. Don't lend on the basis that you intend to fight nature, which is often impossible. Just go with the flow.
Take huge comfort in the fact that the flip side to illiquidity is stability. Peer-to-peer lending returns are very stable because the interest rates are priced at the beginning and then lenders hold onto loans until they're repaid.
If P2P lending instead became like the stock market (it won't), it would mean wild price swings. People dip in and out all the time in shares and it causes a lot of volatile prices. If the same happened when lending, it would mean you might have to pay more than the loan is worth. Or, when you sell, you'd have to sell for less than it was worth. Since prices are usually fixed or nearly fixed, this happens a lot less in money lending.
For a whole load more tips on this, read 10 Ways To Get Your P2P Lending Money Back!
P2P lending risk 9: lost capacity to earn from unlent money (cash drag)
When your money is held in cash in your lending account, waiting to be lent out, you're not usually earning any interest on it. It's like having it in your current account, so even having it in a savings account paying 1%-2% interest would be better.
Cash drag is not usually a big problem. When a P2P lending site is on a roll, just a small proportion of your money is not being lent out, so it only reduces your overall interest rate by a fraction of 1% per year. When a P2P lending company is suffering a shortage of loans, it's usually so obvious that you can simply move a load of money out.
Cash drag can be more frustrating when you're lending in P2P lending companies with a minimum lending amount of £1,000 or more per loan. It can take a while for sufficient interest and repayments to come to you before you have enough to lend the money again.
Don't make the mistake of thinking that your risks are higher if you have unlent money. Yes, your overall interest rate is lower when you consider the 0% you're earning on your unlent money. But the money not being lent is also not at risk.
So cash drag actually lowers risks as well as lowers interest rates. Because no borrower can default on it and it remains your cash in a segregated client bank account.
Also, if the segregated account is run through a regular high-street bank, you probably have protection in the event the bank goes under. (See Which P2P Lending Sites Offer FSCS Protection?)
How to limit cash drag
You shouldn't be lending in P2P lending companies that have a £1,000 minimum per loan unless you're lending tens of thousands of pounds, because you won't be diversified enough. Once you're lending this much money, it won't take you long even in these accounts to earn enough interest to lend your money again.
Keep a rough tally of how much money is not being lent. It should usually be small amounts or for very, very short periods. If it's frequently 20% or more and this is lasting for over a month, think about redeploying your money. Usually it should be a lot less than this.
P2P lending risk 10: reduced real earnings due to inflation (inflation risk)
Inflation is rising prices, so if you save £3,000 and then your annual holiday costs in the Peak District goes up in prices from £3,000 to £3,300, you can't actually afford the same holiday comforts as last time.
Inflation doesn't just affect savings, but, to a lesser extent, it also impacts investments, including P2P loans. You might be earning an 8% interest rate, but in real terms you're only getting richer at half that speed if prices are rising at 4% per year.
This is a risk that peer-to-peer lending shares with virtually all investments. Everything becomes less attractive when the rate of inflation is rising rapidly or when the overall rate becomes sky high.
What to do about inflation risk in P2P lending
In money lending, interest rates after bad debts don't usually rise in line with inflation as it shoots upwards, but the rates do get there in the end. When inflation growth slows down and plateaus, investments typically become especially attractive.
So it might have quickly risen to 4%, 5%, 6%… and that rapid rise is where your real lending results (your results after accounting for inflation) won't do so well.
But then the growth rate slows to 6.3%, 6.4% and then stabilises at that level. It's during this slow down and stabilisation that you might already start to again reap real benefits of staying committed to investing. When inflation falls, you'll certainly be doing better.
Make sure you're lending in some lending accounts where the loans are shorter term, so that you're quickly able to redeploy your money in newer loans that have higher rates to compensate for inflation risk.
Accept the fact that the inflation rate is different every year and that your real lending returns will also therefore vary.
Whatever you do, don't chase ever higher investment returns – and higher risks – to stay ahead of inflation at all times. Good investing and lending sometimes involves accepting that inflation is just not beneficial for anyone who has a pot of money.
P2P lending risk 11: reduced earnings due to legal or tax changes
As with all investments, any legal or tax changes could impact the interest you earn.
The changes so far, thankfully, have made P2P lending more attractive: the government removed a silly problem where you couldn't offset bad debts against interest earned in P2P lending accounts.
P2P lending interest is now tax free to most people due to the personal savings allowance. And it's completely tax free to all if you use IFISAs.
In some rare cases, in some rare P2P lending accounts, it's theoretically possible to make a loss on some loans due to taxes. But that's really very rare, and making an overall loss due to taxes across all your loans in one of these rare P2P lending accounts is highly unlikely. It's just not going to happen to many lenders in practice.
For more on taxes, see How Is Peer-to-Peer Lending Taxed?
P2P lending risk 12: losing money from foreign currency fluctuations (currency risk)
If you lend in a currency other than your own national currency, you can make bonus gains when your currency and the foreign one move in your favour. However, you can also lose money when currency pairs move the other way.
This risk makes it into last place on the list not because it's the smallest or least common risk, but rather because it's optional: it's self inflicted when lenders decide that the additional risk is worth it – and it often is.
I'll give you an example of currency moves. At the beginning of January 2016, €1 was worth 1.08 Swiss francs (CHF). Seven years later, €1 is worth 0.98 francs. That's not a huge move for this pair, but in recent times at least it's been “normal”.
If someone in euroland lent CHF 1,000 through Swiss P2P lending provider LEND during that period, it might have boosted your gains by around €30 (3%) by the time you sold up. This is nothing compared to the approximately €350 (35%) gains made in interest earned. Importantly, if the reverse had happened, it wouldn't have eaten dramatically into your lending results either.
But this is not to say that changes in currency pairs can't make a very, very substantial difference at times. In a couple of years in the late noughties, the British pound lost around a third of its value against the euro (although it recovered a fair bit in the following years).
What to do about currency risk in P2P lending
- Lend more in loans in your own currency.
- Look for currencies that attempt to peg to your own one. For example, the Bulgarian lev has been pegged at 1 lev to €0.51 since 2001, with no break in the peg so far. So long as it's fixed, you'll have no losses (or gains) from the currency differences.
- Lend in loans across many different currencies to attempt to even out the risks, rather than placing all your eggs in one basket. This is the guidance from the phenomenal Credit Suisse Global Investment Yearbooks and Sourcebooks when investing.
- You can hedge your bets by buying what's called forward contracts, but that is generally very expensive. Instead, look to lower your exchange costs. If you transfer directly from your bank or card provider to a lending account in a foreign currency, you won't even get close to the interbank exchange rate (the “real” exchange rate). So, instead, transfer your money through one of the two cheapest exchange providers in the world: Wise* or CurrencyFair*.
There are two more risks for IFISAs
Those peer-to-peer lending risks are the biggest ones that might lead you to lose money.
IFISAs have two additional risks (and one feature that reduces risks) which you can read about in IFISAs: What Are The Risks?
This was part four of our ten-page P2P lending guide
Read part three: 4thWay's 10 P2P Investing Principles.
Read part five: 4-Step Strategy to Safe Peer-to-Peer Lending.
See the contents of the whole 10-part guide.
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Other pages linked to in this guide
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