Peer-to-Peer Lending Definitions
This is our glossary of terms giving you all 4thWay's peer-to-peer lending definitions.
Assets are property or items that have real value.
In P2P lending to individuals, this could be valuables, cars, yachts or houses. Business assets could be property, plant, machinery, equipment or even invoices that good customers are due to pay.
All these things have value. When P2P borrowers have them, it can add a huge layer of protection for lenders.
Bad-debt provision fund
A bad-debt provision fund or “reserve fund” is a pot of money that some peer-to-peer lending companies set aside for emergencies. They use this to pay you your money back when a borrower fails to do so. The provision fund also usually pays you the interest you're owed.
A bad-debt provision fund might pay you right away, as soon as a borrower's payment is late, so that you don't even notice the payment was going missing.
Alternatively, you might have to wait one to four months, although it will still cover any missing interest.
Finally, if the P2P lending company also does secured lending, it might only pay you back from the provision fund after it has tried to recover the losses through repossessing the property first.
In the world of P2P, there is no significant difference between a P2P bond and an interest-only P2P business loan.
You lend your money, get paid interest usually on a monthly basis, and at the end of the loan the borrower repays you the amount you lent. Most P2P bonds last five years or less.
P2P bonds are usually secured and there is no difference with secured loans. Just like P2P loans, P2P bonds can be ranked first, second or joint with other debts. (See “First charge” and “Second charge”.)
So far, P2P bonds have been issued to small or medium-sized businesses only, and not to larger businesses.
Confusingly, P2P lending websites – just occasionally – issue their own bonds, which means you lend to the P2P lending websites. As such, you are not lending to lots of borrowers P2P style, but to one business. Consequently, you should treat such a bond as an individual loan, and spread the rest of your money out elsewhere accordingly.
The only other point of note is that bonds are usually secured.
The technical difference between bonds and loans
The technical difference is that a borrower “issues” – or sells – bonds, whereas a loan is issued by the lender.
Outside of the P2P world there are two other relevant differences:
1) Loans can't usually be traded whereas bonds can. Inside P2P, both can usually be traded.
2) Non-P2P bonds are typically for 10+ years, whereas most non-property loans are for less than five years).
Traditional (non-P2P) bonds
P2P bonds are drastically different from many other types of bonds, so here is a run down from other areas:
If you have a pension and you don’t know what it’s invested in, you probably own some non-P2P bonds.
These bonds are loans from investors to governments or to businesses.
On the risk and reward scale, government bonds are roughly as safe as savings accounts.
Non-P2P bonds to businesses fit into four loose categories, largely distinguished by their size:
1. Corporate bonds and 2. retail bonds
Corporate bonds are very large and typically last ten years or more, although retail bonds are generally still pretty large at around the £100 million mark.
In terms of risk and reward, corporate and retail bonds generally sit between savings accounts and peer-to-peer lending (although there's a lot of variation), because the companies you're lending to tend to be larger and safer.
This means the risk of rapidly losing money is potentially smaller than with peer-to-peer lending, but the risk of your wealth being eaten by rising prices over the longer run is considerably higher, due to the much lower typical interest rates.
3. Mini bonds
Mini bonds are smaller and less safe than corporate or retail bonds. It's too early to say how these compare to peer-to-peer lending, but the interest rates seem low for the risks involved and it is not easy to sell them to exit early.
4. Peer-to-peer lending bonds
The final category is peer-to-peer lending bonds. These are, so far, to small- and medium-sized businesses and are generally in the low millions or hundreds of thousands.
“Savings bonds” offered by banks are a different kettle of fish altogether. For all intents and purposes, those are really fixed-term savings accounts, and so you should view them as such.
First charge or “taken into trust”
A secured loan might have a first charge or the security can be “taken into trust”.
Both of these just mean that, if the borrower is unable to pay its bills, you will be first in line to get your money back, including interest, when the property is sold to recover losses. Other lenders are later in the queue than you and will only get any of their money back after you have got all of yours.
A loan that is ranked first in this way can also be called “senior debt”.
As far as we individual lenders are concerned, this is the most secure form of secured lending.
Compare with “second charge” and “personal guarantee”.
A fixed charge is any “security” that the borrower is not usually allowed to sell or destroy. It includes first and second charges. Contrast with “floating charge”.
A floating charge is any “security” that the borrower is usually allowed to use up, which could be business plant and machinery or cash in the bank.
It is a far weaker form of security than a fixed charge, since there might be no security left by the time the borrower becomes unable to repay the loan.
Many business loans are secured with fixed-and-floating charges, which tend to be more floaty than fixed, and the security is not usually properly valued by the P2P lending site in these cases. 4thWay usually finds that fixed-and-floating charges perform perhaps marginally better compared to “unsecured loans” when it comes to collecting on bad debts, but this is often offset by more of those loans going bad.
Growth investing is investing in shares of business that you believe are going to grow very rapidly. Growth investors will often pay seemingly high prices for shares compared to value investors, in the belief that current prices are fair due to the huge prospects for the business in future years.
Contrast growth investing with value investing.
Inflation is when prices go up.
That’s the prices of bread, medical prescriptions, plumbers' services, and everything else that we buy.
The problem is that, if prices rise 3% and we have only earned 2% in a savings account or cash ISA after tax, we have become poorer, not richer. And that's even though our savings account balances look larger!
So the interest we earn, after tax, has to match the inflation rate in order for us to preserve our wealth.
Governments cause prices to rise, mostly constantly by sanctioning more money to be created at the press of a button, and then finding creative ways to multiply this money and flood businesses, and then people, with it.
More money swimming around for roughly the same amount of goods and services means that prices rise.
Other things can also cause price spikes and dips, but that's not the main cause of inflation or, usually, a long lasting one.
Governments create inflation because it makes it easier for them to repay their debts, even though it makes it harder for responsible savers to preserve their wealth.
This is why inflation is called a “stealth tax”: it takes from savers to help out borrowers.
Governments often accompany inflation policies by forcing banks, pension companies and other businesses to lend more to the government – using the extra money that was printed.
With more people being forced to compete to lend to the government, it pushes down the interest rates the government has to offer in order to successfully borrow more.
A loan that is junior to other loans means that those other loans will be repaid first in the event that the borrower is unable to repay all debts. See “Second charge”.
Loan-to-value (or LTV)
If a property is valued at £100,000 and the borrower borrows £70,000 then this is 70% loan-to-value, or 70% LTV.
It means that lenders have an estimated buffer of 30% if the property needs to be sold to recover the debt.
However, just because the loan is smaller than the property value, there is still a risk to individual lenders of losing money. The main risks are:
- Most peer-to-peer lending companies have surveyors physically inspect the property, but even then it might be valued incorrectly.
- The price of the property might fall.
- The costs of chasing the borrower, repossessing and selling the property might add up to thousands of pounds.
- You might face delays in getting your money back. Recovery procedures can take many months. (Although your P2P lending company might reimburse you earlier through a bad-debt provision fund.)
Business borrowers sometimes give their “personal guarantees” that they will repay a business loan using the owners' and directors' own money and property, if the business is unable to do so. They will often support this by submitting evidence of their wealth.
Some people call personal guarantees “secured lending”, but it is a considerably weaker form of security and no-one here at 4thWay considers it to be a form of security.
Often, personal guarantees are taken when it is not possible to get “proper” security, which indicates higher risk by itself.
It's also not usually possible to force borrowers to hold onto their property, money or other wealth with a personal guarantee.
Initial statistical evidence from the industry collated by 4thWay shows that personal guarantees are usually of minimal or no value when it comes to recovering bad debts. It remains to be seen whether personal guarantees reduce the chance of debts going bad in the first place.
See “bad-debt provision fund”.
Residual method of valuation
Most developments probably don't involve the bulldozering of large chunks of useable buildings. (Where buildings already exist, developers more typically redevelop and renovate those buildings.)
However, when this happens, you will be particularly grateful for the “residual method” of valuation, which is used to value the current, pre-developed site.
A development site's value is higher when it already has official planning permission to create a building that any reasonably talented developer could sell for a profit to a reasonably talented landlord who could let it for a profit.
Unless a developer comes up with an even better idea for the site, it is likely that the development will be completed by someone, at some point, even if it is not done so by the existing developer.
Therefore, the residual method first takes the expected sale price of the property and then deducts all the costs of development – from the sale costs, to the developer's loan interest costs to the construction and deconstruction costs, as well as a contingency for unforeseen costs. You also deduct, say, 15% for the developer's profit.
What is left is the current value of the site – the residual value.
Since a lot of factors are involved in the residual method, and they are forecasts of the future, it is trickier than doing an ordinary valuation based on the existing property and current local property market prices.
However, the current value based on local prices won't have much value after the developer comes swinging the wrecking ball.
Second charge (and mezzanine finance)
A secured loan can have a second charge. (Yes, and third charge.)
This means that there is another, pre-existing loan secured against the same property has a higher priority than yours (a first charge).
Let's say that you have lent money to a borrower with second-charge security, and the borrower can't repay, so the property needs to be repossessed and sold. You will only be able to recover your money after the lenders with a first charge have got all theirs back, including the interest they are owed.
Loans that are not ranked first can also be called “junior debt”.
Mezzanine finance works pretty much the same way. This is when a borrower borrows, say, 50% of the property's value from some lenders, and then another 25% from other lenders.
The lenders who lent the first 50% get repaid first, including interest. Those who lent the next 25% – the mezzanine finance – get repaid last. In return for the extra risk, mezzanine lenders should expect to get higher interest rates.
A second secured debt could increase the risk of the borrower being unable to pay the first debt. So a first-charge holder must normally agree before the borrower can get another charge.
It might do so if it thinks the secured loan will improve the borrower's finances, e.g. by keeping it afloat during a difficult time or because the loan will be used to improve the borrower's property and increase it's value. It could also simply accept a second charge if it sees no risk.
Second charges on P2P loans add a layer of complication in assessing the risk to lenders. The mere presence of a second charge can indicate higher risk.
Secured lending and security
Sometimes a borrower can't or won't repay all of a debt. When this happens, it can be possible for a P2P lending company to repossess their property and sell it, so that it can reimburse us lenders from the proceeds.
Getting a court order to repossess and sell a property is a bit easier to do if the loan is “secured” against the borrower's property and possessions before the contract begins. (Contrary to popular belief, it's not impossible with an unsecured loan. Just more difficult.)
And it's even easier to do this if the property is not inhabited by the borrower and his or her family. So we're talking buy-to-let property, offices or shops, as opposed to residential homes, or other security, such as cars and yachts.
The property that has been put up for the loan is called the “security”. So a buy-to-let landlord “secures” the loan against the property, which becomes the “security”.
Sometimes the security is not related to the loan. There might be a loan to an individual who is not buying a house, but the loan might be secured on his/her house, or on a car or other assets. Sometimes multiple vehicles or properties are taken in security.
It is normal to lend considerably less to the borrower than the property valuation, so that there is room for error and so that there is breathing room if property prices fall.
Secured lending doesn't have to be against land and buildings. You can secure loans against yachts, TVs, art collections, wind turbines and much more. Real property (real estate) is usually among the best type of security, since it is usually easy to value, demand for it increases constantly and its value tends to rise over time.
Not all security is equal in legal terms, as it can put different lenders in different places in the queue when recovering bad debt. See “first charge”, “second charge” and “fixed charge”.
The quality of the security becomes more questionable when the lenders hold on it decreases: see “floating charge” and “personal guarantee”.
Secured loans to businesses
Secured business loans are frequently – but certainly not always – drastically different to loans secured against land, buildings, vehicles and other valuable items.
Business loans are often secured against whatever cash, inventory and equipment the business has, which might be worth considerably less than the loan, the value of the security might be going down in value, and it might be being spent or used up by the business.
Such security can still be better than unsecured loans, in that it can put you at the head of the queue if there are unsecured lenders.
In the P2P lending industry, most – but certainly not all – business P2P lending websites either do not value the security or do not share their valuations with individual lenders.
Hence, with secured business P2P loans, it often makes full sense for individual lenders to focus on such things as bad-debt rates rather than rely on security to bail them out.
A loan that is senior to other loans means that it will be repaid first in the event that the borrower has other debts.
Sometimes, more than one loan can be equally ranked as senior, in which case the loans are usually repaid proportionally.
For example, a borrower has just £1,000 in cash and other assets and it is unable to repay two debts, one for £9,000 and the for £1,000. Assuming they were both senior – equally ranked – one borrower will receive £900 and the other will get £100.
If the loan for £1,000 was senior and the other loan was not, the entire £1,000 loan will be repaid first.
See “First charge”.
If a borrower is in trouble, he is likely to try to repay secured lenders before you, so he doesn't lose his home or his buy-to-let property, perhaps.
Unsecured loans are further down the pile when it comes to recovering money.
Contrary to popular belief, if a borrower stops paying an unsecured debt, the lender can easily get a court order on your property. Whenever the property is eventually sold, the lender can take a piece of it before the borrower gets anything.
This is not theoretical. It is extraordinarily easy to get such a court order. It can only really go wrong, at least with personal loans, if there was a technical flaw with the application.
The unsecured-turned-secured lender can then go one step further: it can get another court order to take possession of the security and sell it. So they don’t have to wait for you.
This second order can be harder to get, particularly if you're talking about a small loan and it would involve chucking a family out of its home. It's at the judge's discretion.
If a property needs to be sold, you will be last in the queue behind any secured lenders. You will still be at the bottom of the pile even if you have got court orders to become a secured lender and to repossess and sell the property.
This doesn't make all unsecured lending bad. Some of the safest P2P lending you can do is to very high-quality borrowers, who often take out personal loans, combined with a decent-sized bad-debt provision fund.
Value investing is investing in shares that you assess to be priced below their value. For example, if shares in a strong business are valued at less than ten times their profits, many value investors are likely to consider it in “value” territory. Alternatively, if the shares are valued at less than all the assets of the business (e.g. its property, plant and machinery) then investors might also consider it a value stock.
Contrast value investing with growth investing.
This might be relevant when buying shares in peer-to-peer lending companies, as opposed to lending through their websites. However, many of the same principles of value investing are also easily applied to peer-to-peer lending itself.