How To Pick P2P Loans To Boost Returns Or Lower Risks
This page was last updated on 18 April, 2017
ON THIS PAGE...
- Why is picking peer-to-peer loans myself a good idea?
- Can I get higher interest and lower the risks at the same time?
- Should I pick individual loans myself?
- How does it work?
- What criteria should I use for picking loans?
- When should you stop lending or change your lending criteria?
- How much should I lend?
- Which P2P lending platforms do you recommend?
Welcome to our latest big guide to get you started in peer-to-peer lending. This one is for those of you who want to upgrade to expert status!
Why is picking peer-to-peer loans myself a good idea?
Selecting individual peer-to-peer loans to lend in yourself is a powerful opportunity to either earn far more interest or to drastically lower your risks.
The reverse can also be true though: some people will be prone to mistakes which can eventually lead to deeply unsatisfactory lending results.
This guide is to help arm you with the information you need to make sure you fit into the first category.
Can I get higher interest and lower the risks at the same time?
In the current market, it is very easy to find several individual loans a week to lend in where you get the benefit of both higher rates and lower risks. That's right – for the time being at least, you can have your cake and eat it.
|Recent examples of lenders having their cake and eating it|
|A £500,000 loan to renovate a residential property in Willesden Green, London before sale. The current valuation of the property is £1.3 million, so the price would have to plummet around £800,000 for lenders to lose money.|
Interest rate: 9%
P2P lending site: eMoneyUnion
|A loan of £150,000 on a farm in Lanarkshire. The farm is valued at £300,000, so the farm price would have to fall 50%.|
Interest rate: 12%
P2P lending site: FundingSecure
|An £802,000 loan on a residential property in Eaton Square, London. The property is valued at over £2 million, so the property price would have to fall over £1 million or more for lenders to lose money.|
Lenders can earn 9% interest on this loan.
P2P lending site: HNW Lending*
|A loan of £650,000 on offices, a workshop and storage units in Birmingham. The premises are valued at £1.3 million, so the price would have to crash around 50% before lenders lose money. In addition, the premises are tenanted and receiving rent. Even if it goes down to 90% occupied, the rent will still cover the mortgage payments 1.3 times over.|
Interest rate: 8.75%
P2P lending site: Proplend*
Why? Because borrowers have rushed into peer-to-peer (P2P) lending faster than savers and investors. And when borrowers are overflowing and there are not as many lenders, we lenders are able to demand higher rates even to high-quality borrowers. We can therefore choose the cream of these loans by selecting them for ourselves.
These situations don't occur very often in investing (for P2P lending is a type of investment).
Indeed, there is no type of investment that is intrinsically both high reward and low risk all the time. However, temporary situations can occur that cause these conditions, which some individuals calmly grasp with both hands to make substantial profits without mopping our foreheads as if we are handling nitroglycerine or throwing dice in Las Vegas.
I'll give you some more recent examples of these situations in other industries: it's akin to buying property in 1995 when property prices were at a major low, or buying shares in 2003 after the aftermath of the dotcom crash. Fantastic properties or businesses were up for grabs at these times at incredible prices. Those who invested at these points will have found it hard to lose money and easy to make a lot of money.
The situation is similar right now in P2P lending. Investors are still being too cautious, just as they were in 1995 and 2003. This explains why, in my firm opinion, interest rates are too high right now for the risks involved at a good number of P2P lending sites.
Should I pick individual loans myself?
Only if you have a non-excitable personality who is interested in putting in the time to learn how to do it right – and if you know how to use checklists!
Ironically, the people who take the most interest in being hands-on with their investments are the ones who are the most giddy about making money. As you can imagine, being giddy while deciding what to do with your childrens' inheritance is probably not the best idea.
Indeed, giddiness is one of the reasons why investors who actively choose their own investments have such a poor record, since they typically do far worse than lenders and investors who simply spread their money into lots of loans and investments and passively keep investing!
That's right, those who spare little thought for what they're doing actually have a better record, on average, than those who try to beat the various investment markets they're in! So it's not because investing is difficult, or even that lowering your risks or increasing your gains is terribly difficult, but because too many active investors picking their own individual loans or investments just get way too excited. And greedy.
I've seen this time and again over 20 years of investing. I've seen such people as a smart mathematician with many years' experience in investing lose all his pension savings as a result of this excitement. And a senior engineer bleed nearly £100,000 by catching a falling knife. (That's investor slang for greedily buying an investment everyone else is backing away from just because it appears to offer huge returns, without properly considering whether it's a safe investment or not.)
Here are some all-too common scenarios that excitable investors and lenders find themselves in, some of which I have personally seen but all of them are well researched flaws that professional investors and smart individual investors alike regularly make:
- They’re excited to invest right away, often because they don't want to miss out on any opportunities, so they don't research properly. Perhaps they dip their toe in, nothing goes wrong for a brief few months, so they plow the rest of their money in with equally less thought. Uh-oh.
- They spend a long time researching meticulously – so long indeed that they aren't willing to accept “defeat”. They therefore ignore any doubts they have and start to look only for reasons why they should invest instead of sensibly looking for reasons why they shouldn't. Their burning inner desire to make lots of money does the rest. (It is never a defeat to say “No” to an investment after lengthy research. Most investments are a “No”. Your research has still armed you with useful knowledge for the future.)
- They look at interest rates first, rather than the risks, and are blinded by those double-digit returns. (Interest rates of 10% or more are not always high risk, but it's important not to be beguiled by the rates first.) The most successful investors – the ones who make the most money and sleep best at night – focus on controlling the risks as the first, second and third priorities.
- They loosen their investment-selection standards because everyone else is doing so, or because there are currently few great opportunities and they don't want to look silly by earning 0.5% with a savings account when others are still making lots more with investments. Perhaps, at the time, lending interest rates have fallen considerably, but because lots of other investors, newspaper pundits and “experts” are piling even more money in, they do too. They are following the crowd instead of making their own independent minds up about the situation. This is the cause of most bubbles and many investors' mediocre long-term returns.
- They start to think that it is safer precisely because other people are piling in, even though this change in the supply-and-demand balance pushes interest rates down. It seems contradictory, but when everyone thinks something is safe is precisely the time when investments are the least safe, because you earn less interest to cover any bad debts that might occur from the next recession.
- They “chase yield”. This is when interest rates are falling and so they keep moving their money to even riskier loans in order to keep their interest rates up. (What they would be better off doing is accepting that lending interest rates might not be good enough for a while and reducing their P2P lending until the situation improves – even if they can currently see nowhere else good to put their money except savings accounts paying little interest. Setting rules to know when to stop is not difficult, but investors' greed all too often overrides those simple rules.)
- Lending in loans, selling them and lending again, repeatedly – buying and selling loans frequently in an attempt to make more money than everyone else. (Competing just so you can say you made more money than everyone else is a disastrous reason to pick your own loans or investments!) While there are special situations where buying and selling loans rapidly is a great idea, it often costs you fees that go to the P2P lending sites. Regularly paying repeat fees, those small slices of your money, is going to seriously reduce your overall gains.
- It's the giddy ones who have done the above that panic when conditions deteriorate. The tide has gone out, and we now know who has been swimming naked – naked of genuine confidence in what they have been doing. They have invested recklessly and now that the property market is crashing, a recession has started and more borrowers are unable to repay, their pub-side smugness is gone. And because they never took the time to research properly to gain that true confidence they need to weather a crisis with a shrug and a smile, they panic. Quite likely they will sell their loans for a big loss (and for the loan buyer's big gain) because they've become worried they'll otherwise lose everything. Then they'll go back to the pub and tell everyone it's a terrible investment, a mug's game, and they're never touching it again.
- They mull over each loan or investment with no reference to checklists. It sounds stupid and simple, but unless you check off all the criteria you have set yourself for evaluating a potential peer-to-peer lending opportunity, you are likely to make a lot of mistakes. (Don't believe checklists are powerful? How about this: a Boeing plane crashed due to human error killing the three on board. Frightened it would lose out on important contracts to build planes for the US Air Force, Boeing then invented the first ever pilot checklists for take-off, in-flight and landing. Millions of test-flight miles later there were no incidents or accidents, and Boeing subsequently sold over 10,000 bombers, many of which were used in WW2. Now, checklists are mandatory on all flights around the world and it is the safest way to travel. Here's another one: infections in hospitals were horrendously high until hygiene checklists were implemented. Almost overnight, infections fell to virtually zero. Checklists save lives and also your investments!)
How does it work?
Each P2P lending site has differences but the process of choosing individual loans and lending usually works like this:
1. You register and open an account.
2. You browse new loans that are in auction. These loans might have a pre-fixed interest rate and be first-come, first-served to lenders, or lenders might be able to compete with each other to lend by bidding lower interest rates. The loans in auction have already been vetted by the P2P lending site (to widely varying degrees of ability or standards).
You are normally able to see a summary of key statistics and details and you can usually see the supporting documents, such as independent valuations of the borrowers' property.
3. On finding a loan you want to lend in, you pledge to lend to a borrower.
4. If the borrower receives enough pledges to reach the amount they wanted to borrow, you then lend your money along with everyone else.
You might also, or instead, browse existing loans that other lenders are looking to sell before the borrower has repaid, and buy those. This is a so-called “secondary market”. (The most famous secondary market is probably the stock market.) Through secondary P2P lending markets, there is no auction period and so you are able to lend your money immediately, since the loan is already live.
You might be able to buy or sell at a higher or lower price on the secondary market, e.g. if the original loan was £1,000 you might be able to buy it for £950 if the existing lender really wants to get out quickly, or for £1,050 if the existing lender thinks that the loan is so attractive that you'll pay more for it. Paying more for a loan effectively reduces your lending interest rate; paying less effectively increases your interest rate. Most P2P lending sites that allow variable pricing normally tell you what the effective interest rate will be. (Read more on secondary markets in Where Can You Buy Or Sell Existing Loans?)
What criteria should I use for picking loans?
You need some criteria – strong lines in the sand – that you use to select loans. These lines are defined by your knowledge of the risks. The more you genuinely understand what could go wrong and the chances of it going wrong, the more leeway you have to set lower standards.
But they should never get too low. You need to feel highly confident at all times that the lines you have set will protect you from making an overall loss even if your loans are running during a major recession and property crash.
Rather than merely asking yourself what criteria you should use, I prefer you ask “What should I put on my checklist that I will always refer to before I buy any loan?” Just to reinforce that you need to be disciplined in selecting your loans, precisely as you'd expect P2P lending sites to be disciplined in the borrowers it allows to use their services. (Just as you'd expect your pilot to run through her checklists or your doctor to check off the hygiene tasks before an operation.)
Here are some lines in the sand to consider as your starting point. By all means modify them as you learn and improve, but remember the warnings I have made throughout this guide about not loosening your standards just because everyone else is or just because it's hard to find opportunities that meet your existing standards.
Property security. A first sensible criterion to get you started is to stick to loans that are secured against real property: that's land and buildings.
Exclude property development loans to begin with, because they are much more specialist and are higher risk, so you’ll need to take extra time to learn more about those.
If and when you're confident doing so you could extend into loans secured against other assets, such as yachts, high-performance cars and expensive household items.
Full physical inspection of the property by an independent, qualified surveyor. There are rare circumstances where it's probably okay if there is no physical inspection of the property and just a “desktop inspection” using online tools and websites is sufficient. However, to get started you might want to avoid any property loans or mortgages that have not had a proper independent inspection. Do make sure you read every word in all the documents and summaries that the P2P lending site offers you, to ensure that full checks were made, because soetimes they aren't!
Huge experience. As usual, stick to platforms where you believe they have the skills and experience required to assess those borrowers for the specific type of loan you're lending in. You can read more on that in How To Assess P2P Lending Websites.
Look for a well-worn path. When looking at a peer-to-peer lending site's list of previous loans, it is usually clear what type of loans they are experts in. Perhaps they do 99% property loans and 1% other assets, which means you are more likely to be able to rely on their expertise and experience in property.
You might find that, within property, they usually do residential buy-to-let mortgages, so if you find a mortgage on an office block, again, consider having a line in the sand to avoid loans off their well-beaten track.
Look for a strong record. Usually this will be a strong record that the P2P site has in low bad debts but sometimes it might be a strong record in recovering debts after a loan goes bad.
Up to 2017, the economy and conditions have been very good for property and asset lenders, so currently you should expect a property P2P lending site’s historical bad debts to have been zero or close to zero. Much more than that right now and you really have to wonder why.
If the record is not clear, perhaps because too little information is provided, assume the worst.
Minimum interest rates and maximum loan amount versus property valuation. The table below shows minimums you might choose to accept before you decide against lending your money, but currently you can expect to earn far more than this.
For the past few months, I have generally found 1-2 loans a week paying 7% to 15% interest at 50% loan-to-value. These are very exceptional returns for such secure, low-risk loans. Therefore all the loans you lend in right now should probably be significantly better than the minimums shown.
Assuming there are no other protections such as reserve funds to cover excess losses (which are rare when picking your own loans), here are some minimum criteria for you based on conservative assumptions of what might go wrong during a severe recession and property crash:
|Loan type||Interest rate||Maximum LTV (see info box)|
|Rented residential property mortgage||3%||50%|
|Rented residential property mortgage||4%||70%|
|Rented commercial property (e.g. offices) mortgage||4%||50%|
|Rented commercial property (e.g. offices) mortgage||5%||70%|
|Bridging (short-term) loans||6%||50%|
|Bridging (short-term) loans||8%||70%|
More interest than savings accounts and cash ISAs. In addition to the minimum rates in the tables above, you should always expect a couple of percentage points more in interest than you can currently get in the best savings accounts and cash ISAs (tax-free savings accounts) available. For bridging loans, make sure it’s at least five percentage points more.
Be first in line to recover any bad debts. The mortgage should have a “first charge” or similar, which means that legally we lenders are first to be repaid in the event that the mortgage goes bad, and the property is repossessed and sold. The borrower, and any other banks or businesses that are lending to that borrower, only get money from the property sale after we have got all our money and outstanding interest.
It is perfectly reasonable to do second- or even third- charge loans, i.e. be paid second or third behind other lenders, but then you should expect even lower loans-to-value and potentially also higher interest rates.
Here’s why. If there is a first charge ahead of yours at 50% loan-to-value, and then you lend 20% of the property price on top of that, your risk is sitting in the 50%-70% range. If the property is repossessed and sold in a property crash at distressed prices, selling at 60% of its starting value, you will lose half the money you lent in that loan.
60% has been repaid, so the lender with the first charge loses nothing at all and you get half your money.
Note that if the lender with a first charge had lent the first 60% and you lent the part between 60% and 70%, you would have lost all your money in that scenario.
Keep to the 10 principles. As a final sanity check, be prepared to reject any loan if you feel that the P2P lending website itself does not meet all 10 of 4thWay’s P2P Investing Principles.
I don't recommend that you pick loans until you personally feel deeply comfortable with the P2P lending site offering those loans. Because if there's a recession, bad debts will rise, and some lenders are bound to panic. On seeing that, you will likely panic too. All the panickers will try to sell their loans early and to do so you might be forced to sell at a loss.
So you need to research a P2P lending site to such an extent that you are able to say “Yes, I don't care that there’s a recession and that a couple of my borrowers are having trouble, I firmly believe that I can still strongly expect to come out of this with positive gains.” Then you’re ready. The 10 Principles are a checklist to ensure you're that confident.
On a similar note, you will need to reassess each P2P lending site regularly based on these 10 principles, since not all the good or fantastic ones today will remain so forever. For example, if the P2P lending site you are using either stops transparently sharing information and data, or if it gives you another cause for alarm, e.g. lots of key people leaving at once, or it clearly weakens its borrower standards considerably. In times like that, you can no longer confidently say you understand that P2P site or the risks involved, in which case you can no longer lend.
When should you stop lending or change your lending criteria?
It’s time to stop lending or reduce your lending when fewer opportunities meet your criteria. Be wise like an owl and patient like whatever kind of bird or animal that is very patient, because at times like that it could take years before a choice of sensible lending opportunities start to come back.
When setting your own lines in the sand, remember that lending is intrinsically lower risk than the stock market, where there is a significant risk of losing a lot of money suddenly, at least temporarily, even if you hold lots of investments.
Therefore, if you find that any lines you have set or changed are making you feel the risks are getting too “stock-markety”, you are probably going too far. It’s perfectly fine to take stock-market level risks and I think most savers and investors should be doing so with at least some of their spare money. But if you want to take stock-market level risk, I think the best place for most people to do so is the stock market, not P2P loans. Don’t try to fight the natural flow of an investment.
Don’t change your lines in the sand just because everyone around you is or because numerous articles have convinced you to or because nothing has gone wrong for a long time. It is precisely at these times, when everyone says “This time it’s different and nothing will go wrong again” – that’s when lots of people weaken their standards simultaneously, investment markets get super risky and shortly after this lots of people lose a lot of money.
At times like this, when all the good deals are gone and everyone else is lending at higher loans-to-value or lower interest rates, it’s better to opt out of earning that interest than to leave yourself in a situation where you could end up having sleepless nights worrying that you’ve done something stupid.
Change your lines in the sand when you have acquired enough knowledge to do so confidently. That will be based on your growing knowledge, but not be based on your past results – which are unrelated to the future. In other words, your assessment is based on the risks involved now at each P2P lending site and for a given loan, rather than letting your assessment be influenced by healthy interest you have previously earned on your own small number of loans.
You have to feel that moving your lines doesn’t leave you with any doubts, even small ones, that what you’re doing might lead to large or permanent losses. If you can’t confidently say that, don’t move those lines.
Basically you need to have a fantastic reason to use looser standards, and the fact that nothing has gone wrong before is not a fantastic reason. It's not even slightly good. “Nothing's gone wrong before” has left many an investor with disappointing results. Bubbles occur when even professional or experienced investors do crazy things because they all goad each other to break their rules.
This actually happens in lots of markets, from the stock market to the insurance market. But I think the most fitting example here is in residential mortgage lending. Here’s what happened there:
From the 1930s to the 1980s banks were well regulated. Homeowners were required to put down 25% deposits to buy their homes. That is a sizeable deposit that protects both homeowners and banks in the event that house prices fall.
In addition, homeowners could only buy with a mortgage if the mortgage was for no more than about three times their household salary. It’s rare for homeowners or mortgage lenders to go bankrupt based on these sensible sort of loans.
By the 1980s, banks, the government, the financial regulator and prospective homeowners had relaxed considerably. Mortgage lenders had made money every year for half a century, therefore it was okay, everyone thought, to relax a bit and loosen the standards. 20% or even 15% homebuyer deposits became acceptable, and mortgages that were 4-5 times the household income became the norm.
Still nothing went wrong. So everyone continued to loosen standards until banks were deliberately lending more than the properties were worth, self-employed people were getting mortgages without supplying evidence of their income, and homeowners could get mortgages for eight, nine or even 10 times their household incomes.
The pre-1980s caution was because everyone knew things could go wrong, but that was forgotten. It was exactly when that fear had all but disappeared, and everyone was saying nothing can go wrong, that it went terribly wrong for a lot of people. That’s when the property crash happened. (Yes there was another crash in between but that's another story.)
This was a particularly protracted event from the 30s to the noughties, but please don’t presume you will also have 80 years of easy money; it could just as easily be 80 months before the more reckless P2P investors – the ones who have no solid lines in the sand – suffer their own major crash.
Over 20 years I've seen so many investors go wrong – just untold numbers of individuals and experts alike, including many fund managers. The temptation to follow the crowd and relax standards just because nothing has gone wrong before is very strong, especially as it gets harder to find good deals.
Please please do not become another one of those people! Missing out on earning some higher interest for a while is better than taking chances. Just don't do it – and get to have a good night’s sleep.
How much should I lend?
You could either pick a few loans to supplement your other P2P lending, savings and investments or you could put all your investment pot into the P2P loans you select individually. Both are perfectly sensible strategies. The main point is that you shouldn’t be putting loads of your money into a single loan.
Lend no more than 5%-10% of your entire savings and investment pot in any individual loan, preferably closer to 5%.
There are no guarantees, but looking at really horrendous, unfortunate results in a very severe property crash and recession, you might see four loans go bad and you lose, say, 20% on each of those four loans. If you have 10 loans, that’s a loss of 8% of the total amount you lent and if you lent in 20 loans that’s a loss of 4%. It won’t take more than a couple of years’ interest to recover those losses.
Also, don’t lend all your money with one P2P lending site. Perhaps set a limit of 40% of your investment pot at any one site. You will probably need to use 4-6 different P2P sites to find enough of the best quality loans anyway.
Which P2P lending platforms do you recommend?
Plenty of peer-to-peer lending sites allow us to choose which individual P2P loans we want to buy ourselves.
Recently, my colleagues and I have been able to find loans paying 7% or more at 50% or lower loans-to-value at the following P2P lending sites. The top choices are the P2P sites that 4thWay has both been allowed to assess in great detail and which, in my opinion, are high-quality P2P lending sites.
FundingSecure. Regularly has opportunities paying 12% interest on bridging loans at 50% LTV or less. It probably has the most opportunities. It does a high number of non-property loans secured on other assets and it has proven expertise with many of these assets, but do your research before expanding to other types of loans.
HNW Lending*. Often pays 6%-11% interest on bridging loans often below 50% or even 40% LTV. (Minimum lending amount per loan is very high at £10,000, or £5,000 if you lend in HNW Lending’s IFISA and invest at least £15,000.) HNW Lending has had nearly as many opportunities of under 50% LTV than FundingSecure in recent months. For simplicity avoid homeowner loans and non-property loans, which are relatively few and far between.
Proplend*. Not so many deals, but it pays around 7% interest on commercial rented property mortgages that are 50% LTV or less. Rented properties are lower risk than bridging loans, since the landlord’s monthly mortgage payments are covered by its tenants.
Assetz Capital*. Assetz Capital does business loans and energy projects, as well as property development loans. But here the focus is its property bridging loans, and rented residential and commercial properties. So the whole property shebang, paying 5%-15%. There are possibly fewer sub-50% LTV deals here, but it does allow you to park money in an easy-access account with a reserve fund and automatic loan diversification while you wait for individual loan opportunities. In ordinary market conditions you can instantly transfer your money out of the easy-access account into an individual loan.
These choices aren’t necessarily worse than the above but we have less information on many of them than we do for those above. Still, if you spread some of your money in the following as well as the above, I expect you to do just fine if you stick to your lines in the sand:
The opinions expressed are those of the author and not held by 4thWay. 4thWay is not regulated by the FSMA and does not provide personalised advice. The material is for general information and education purposes only and not intended to incite you to lend.
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