Peer-to-Peer Lending Glossary And IFISA Glossary
This is our glossary of terms, giving you all 4thWay's peer-to-peer lending definitions and IFISA definitions.
The 36H Group represents investment providers that operate electronic lending platforms using so-called “article 36H” P2P lending agreements. Such platforms are what the financial regulator calls “peer-to-peer lending platforms” – although 4thWay's definition of P2P lending is wider than the regulator's.
The 36H Group is part of Innovate Finance, which is a lobbying association that also represents a very different kind of investing called equity crowdfunding.
An administrator (otherwise known as a “receiver”) is someone appointed to wind down a peer-to-peer lending platform or IFISA provider, if it has failed or gone bust. They are insolvency practioners who are usually accountants by background.
Administrators are expected to attempt to return as much money to lenders as possible by taking over the management of the existing loans until they are all repaid.
The administrators have another duty, which is to ensure that businesses owed money by the P2P company itself also get as much of their money back as possible. Those debts are distinct from the debts owed directly between the borrowers who used the online lending platform and the lenders who used the online lending platform. (Read more under peer-to-peer lending.)
Usually, multiple administrators are appointed from one firm of accountants who specialise in insolvency. (That's why you usually see the plural of administrators and receivers.)
In the UK, administrators in this industry are appointed with approval from the financial regulator, the FCA.
The right to build or develop in the airspace above a property.
A developer should have these rights before borrowing to develop in such spaces.
Homebuyers might buy two homes and sell one, while retaining air rights above it, so that they can build sideways above their remaining property and over the other one.
With increasing frequency, office blocks in dense cities have overhangs and and even complete office spaces over the tops of older buildings.
When an interest rate, bad-debt rate or some other percentage rate is annualised, it's presented as the average change over any 12 months.
For example, if you earn exactly 1% interest every month and you withdraw the interest each month to your bank account, you're earning 12% annualised interest.
For you, lending £100 would ean you £1 + £1 + £1 + £1 + £1 + £1 + £1 + £1 + £1 + £1 + £1 + £1 until the end of the year, for £12.
If you re-lent the 1% interest as soon as it's paid to you, the annualised interest is 12.68%, because you'll earn interest on top of your interest. Like this: £1 + £1.01 + £1.02…with an ever increasing interest each month.
Whether you lend for one day or 10 years, or anything in between, the annualised interest rate is still 12.68%. This means your money is working just as hard for you as it is for someone else who lends in the same loans as you for a different length of time. That's why annualisation is so useful – it makes performance easier to compare regardless of length of time you lend.
One more example: if you lend £100 today and suffer bad debts of £10 in exactly two years' time, you've had 10% bad debts. However, on an annualised basis, you've suffered 5% bad debt, because it took you two years, not one year. You've also been earning interest for two years, so you need to earn 5% interest per year – that's annualised – to cover your bad debt, and not 10%!
Some P2P lending to businesses is secured by the borrower for lenders' benefit using a legal device called an all-asset charge. This means that whatever property, machinery, cash or other assets are available at the time a borrower is chased for a bad debt can be sold on behalf of the lenders.
It's not usually the strongest form of security, but it does improve recovery of bad debt. It's often accompanied by covenants, such as a requirement for borrowers to maintain a certain level of assets or be required to repay the loan in full.
(See Assetts and asset-backed lending. See Covenants.)
Assets and asset-backed lending
An asset is property or items that have real value. Asset-backed lending is when you lend to a borrower who has specifically put up one or more assets as collateral. A peer-to-peer lending site can repossess the asset (if it is not already held in possession) and sell it to recover any bad debt.
In P2P lending to individuals, this could be houses, cars (especially luxury models), yachts, fine wine, art, antiques or jewellery.
In lending to businesses, physical business assets could be property, land, plant, machinery, equipment or cash in the bank.
Another common type of asset is customer invoices: if the borrower is a business and it's owed money by customers, the asset transferred to lenders is the right to some or all of the money owed by the customer.
Some types of secured lending are more loosely based on whatever assets a business or person happens to have left when they become unable to pay their bills. (See All-asset charge.)
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 (also “provision fund”, “reserve fund” or “contingency fund”) is a pot of money that some peer-to-peer lending companies set aside to cover expected bad debts. 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 or IFISA provider 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.
When a provider starts offering a reserve fund, you need to check that the money is truly segregated from its own bank accounts, and that it can only be used to help you and other lenders recover bad debts. If it isn't truly, legally separated, then there is a risk that it will not pay out at some point in the future. The funds would instead be used by the provider, potentially to pay its own debts.
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.
A bridging loan is a short-term loan secured against property. (See Secured lending and security.)
This might be to buy a property at auction before a proper, long-term mortgage can be arranged, or a temporary loan prior to getting tenants so that a cheaper buy-to-let mortgage can be arranged.
A bridging loan is also used when you buy one property before you are able to sell off an existing one, “bridging” the gap in a property chain.
These loans often involve temporarily over-extending a borrower, so that they have more debt than they otherwise would be able to take.
See development loan, below, because there can be some overlap.
A brownfield site is land that was previously developed. It could potentially be redeveloped.
Some P2P lending sites allow lending to borrowers who are seeking to get planning permission to develop a brownfield site that they own, or lending post-planning permission to develop such sites.
In US English, brownfield site has a different meaning: abandoned industrial land that is somewhat contaminated.
See personal loan.
Loans are often approved if a borrower agrees to legal covenants. For example, this could be a requirement that property used as security by the borrower continues to have tenants that are paying rent above a minimum level. Or it might be that borrowers are required to maintain a certain level of assets. If covenants are breached, the P2P lending company could require the borrower to repay in full.
Credit analysis is looking at all the facts in a systematic way, based on pre-set criteria, to decide whether a loan application should be approved, and at what interest rate. It is an assessment of the risks in approving a loan for a particular borrower.
Credit analysis can sometimes be more of a qualitative assessment, which is especially the case for larger, more complicated property loans, such as short-term bridging loans, but still working within the framework of pre-set policies and procedures.
A credit committee makes the final decision on whether a loan is going to be approved.
The committee sometimes also has the final say on the policies and procedures that are used for assessing and approving loans, when this final word doesn't go to the head of credit. The committee might also collectively monitor performance of existing loans.
There is no legal definition of the word creditworthy. However, it's usually used to mean borrowers who are believed to be very likely to repay their entire debts and interest, without falling into trouble along the way.
Creditworthy borrowers usually have an income that can be used to meet loan payments, and they usually pay lower interest rates. However, it is not necessarily limited to just “prime” borrowers (which is another term that has no legal definition).
The word “creditworthy” is not generally used for payday lending, because the proportion of bad debts is very high.
It's also not usually used when talking about short-term lending against property and possessions, if there's no income being earned directly from that property. While recovery of bad debt on those loans can be high, it is quite typical that many of the loans turn bad.
One platform might call a borrower creditworthy, while another does not. Ultimately, anyone who successfully repays a loan, or would do so if offered one, is creditworthy. It's up to each bank or peer-to-peer lending company to weigh the facts and decide if this is likely or not.
A development loan is a loan to develop a building site. This might include tearing down existing premises, completing groundworks and putting up a new building. Or it might be renovating an existing building.
Usage of the phrase “development loan” varies. Some businesses approve loans for the initial purchase of a site or to hold onto a site prior to getting planning permission, and they still call these development loans. Other businesses classify those loans as pre-development loans or bridging loans.
Development loans are often approved in tranches.
When you spread your money across lots of loans, you have diversified your risks. Diversification is the single most important task of an investor who makes money through money lending.
Take for example the lender who lends in just one development loan. Something might easily go wrong with the development; for example, if the grounds prove to be far more problematic to build foundations on than the initial survey projected. Costs could then spiral and the project could fall behind – and into trouble. The lender might easily lose money.
However, if you're lending across many dozens of development loans, the risk of all of the developments suffering the same problem is practically zero. The more loans you are in, the lower the risk of suffering poor results from bad luck.
Borrowers sometimes have a loan limit approved, but are not required to take the full amount right away. To keep their costs down, they “draw down” the loan – take chunks of it – when they require it.
In some cases, a draw-down schedule is fixed in advance, and the borrower needs to meet conditions before drawing down more money. These draw downs are called tranches.
Equity crowdfunding is investing in startups by buying shares in them through online investing platforms. It makes a stark contrast with P2P lending. Money lending – including P2P lending – is typically a stable and relatively low risk type of investment. Whereas buying shares in startups is typically a very high-risk investment.
See Financial Conduct Authority.
Financial Conduct Authority
The Financial Conduct Authority (FCA) is the UK's financial regulator. Its job is to protect those who buy financial services, such as P2P lending and IFISAs. It has the power to sets rules for financial businesses and punish them for non-compliance. It has no authority over investors, including people who lend through P2P.
The FCA does a lot of work to screen out applications to run a P2P lending company:
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Financial Services Compensation Scheme
The most important purpose of the Financial Services Compensation Scheme is to protect people from losing money in bank accounts and savings accounts, in the event a bank goes out of business or runs out of money.
Money that you're currently lending is not covered by the FSCS.
Because money lending is an investment, and investment losses are never covered by this scheme, whether it's the stock market or anything else.
However, the scheme isn't completely irrelevant in peer-to-peer lending.
Unlent money that you have deposited with peer-to-peer lending platforms or IFISA providers is often covered by the FSCS, because the cash is typically held in a bank account covered by the scheme. (Read Which P2P Lending Sites Offer FSCS Protection?)
The scheme could also compensate you if you've received inappropriate investment advice from a regulated financial advisor.
The FSCS is a government-enforced scheme funded collectively by the banks and many other regulated financial firms.
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”, and see also “fixed charge”.
A fixed charge is any security that the borrower is not usually allowed to sell or destroy, so that P2P lending sites can be more confident the security will be available to repossess and sell in the event the borrower is unable to repay in full.
When a loan is secured against real property (real estate), vehicles or other physical assets, it is usually with a fixed charge.
A fixed charge can be a first charge, second charge or lower.
Contrast with floating charge.
The amount of new money you can put into an ISA each tax year (from 6th April to 5th April the following year) is capped. With a flexible ISA, if you put new money in, you can withdraw it and put it back in again without losing part of your capped allowance, provided you put it back in again before the next tax year starts.
Cash ISAs, share ISAs and IFISAs can each be flexible or not. To find out, check with the provider or in 4thWay's IFISA comparison table.
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.
See Financial Services Compensation Scheme.
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.
Head of credit
The head of credit is in charge of the credit team (which might be a team of one in smaller companies).
The head of credit is usually responsible for setting up the policies and procedures for approving borrowers and setting interest rates. In small P2P lending companies, this task is sometimes outsourced to a more experienced freelancer.
A head of credit will typically monitor performance, maintain standards, and often be the one to determine if a borrower is too risky or doesn't fit with the desired profile.
One aspect of good lending is setting interest rates and/or borrower grades correctly. If bad debts rise smoothly with interest rates and borrower grades, they are said to be heterogenous or, more commonly, to have heterogeneity.
If a peer-to-peer lending website doesn't establish heterogeneity, this is a very strong signal that they do not understand their borrowers.
Individual lenders, or researchers such as those at 4thWay, can assess heterogeneity when a P2P lending platform or IFISA provider shares its full historical loan book, showing the details and loan status of every loan.
Innovative Finance ISA or IFISA
Tax-free lending accounts for residents of the UK that may or may not involve peer-to-peer lending.
You can lend to a wide variety of people, businesses and property owners through different IFISAs, although most of them either limit your lending through one peer-to-peer lending site or, if not, they come with additional costs.
Most people do not need to pay taxes on their lending even when using ordinary P2P lending accounts and it is not sensible to decide what to invest in purely based on tax advantages. There are other restrictions to IFISAs that could prevent you from spreading your money around widely enough.
For many people, a combination of ordinary P2P lending accounts and IFISAs is the most sensible way to satisfactorily contain the risks. Read about when to use IFISAs in The IFISA Guide.
4thWay lists P2P IFISAs only, since direct lending between individual lender and the end borrower (so-called “peer-to-peer”) reduces the risks.
(In case you care, IFISA in full stands for Innovative Finance Individual Savings Account, but despite the word “savings”, lending is actually a form of investment.)
A loan that is “in default” is a bad debt.
It varies how or when P2P lending sites define their loans as in default. And the definitions change over time due to individual P2P sites' discretion, coordination from the P2P Finance Association, or updates to rules laid down by financial regulators.
Although there is room for interpretation, for UK-based peer-to-peer lending companies, parts of the definition is regulated by the Financial Conduct Authority. The UK's financial regulator says that loans that are 90 days late for a payment, or for repayment, are to be classed as in default. For property loans, it's 180 days.
Those time limits aside – and in P2P lending sites not regulated by the FCA – a peer-to-peer lending company might also class a loan as in default when it has started recovery proceedings. They might also class a loan as in default if it needs to be extended or otherwise renegotiated.
In some cases, if a P2P lending site sees that there is a good chance the borrower will be unable to repay a loan, it might also class the loan as in default.
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.
Invoice finance is when you lend to business borrowers who put up amounts owed by customers as collateral. These amounts are shown on customer invoices – hence the name of this kind of lending.
In some cases, a P2P lending platform/IFISA provider can arrange for customers to pay them – or even to pay directly into a segregated account for lenders.
In other words, the borrowers' customers don't pay the borrower. The customers pay through the P2P lending company. The P2P lending company disburses the loan and interest to lenders, while returning any excess to the borrower.
In invoice finance, the borrower and P2P lending company might agree in advance which invoices are to be used as collateral. Or the collateral might be based on all the borrower's outstanding invoices instead.
For longer-term lending, the collateral could be rolling: when existing invoices are paid and new ones are drawn up to replace them, those new invoices become new collateral for the loans. In this case, borrowers are required to maintain a level of sales and invoices, or they will face conditions that could involve the full debt being called in immediately.
Invoice finance branches into what is called invoice discounting and invoice factoring. On balance, the distinction is more important to the borrower than lenders. In any event, the lines between them sometimes blur to the extent that the names themselves have little meaning.
From a lender's point of view in peer-to-peer lending, it's most important to understand the inherent risks. For example, this means ascertaining whether specific invoices are taken as collateral, whether the invoices are rolling, how long the loans are for, and how easily the cash paid by the customers can be diverted to the lending account.
An institutional lender in peer-to-peer lending can be a bank, pension fund, private lending business, an investment fund such as a hedge fund or investment trust, an insurance company, or another financial-services business.
Institutional lenders lend their clients, customers, shareholders or members' money through peer-to-peer lending sites.
They might lend online by opening an account in exactly the same way as individual lenders, or they might be offered separate deals and a different way to lend.
The institution might be treated preferentially to individual lenders, or worse, or exactly the same. Read more about the many different ways P2P institutional lending happens in Is Institutional Lending In Peer-To-Peer Good For Individual Lenders?
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. Therefore, if such a borrower becomes unable to repay such a loan, the risk of lenders losing money is higher – sometimes considerably so – unless the peer-to-peer lending site or IFISA provider has very tight criteria in approving those loans.
In peer-to-peer lending, the loans that rank above a junior loan might have been provided by one or more banks, or by smaller, non-bank lenders. Alternatively, they might come from other P2P loans through either the same P2P lending site, or one or more other P2P lending sites or IFISA providers.
There can be several tiers of junior loan, all sitting below the most senior loan and either ranked consecutively or ranked equally, or a mix of the two.
The rank of a junior loan needs to be properly agreed through legal and contractual means. See “Second charge” for more.
Junior loans are sometimes called junior debt, mezzanine finance, mezzanine loan, subordinated debt or subordinated loan.
Liquidity means how easy it is to get your cash back early – before borrowers repay your loans. The natural life of a P2P investment is usually the full length of a loan. You can't always fight nature, so it will sometimes take longer to get your money back.
Liquidity can also refer to how much cash flows through a bad-debt reserve fund. If it's very liquid, there's a good supply of cash ready for instant use. Illiquid funds might have enough planned bad-debt coverage, but they don't have enough cash immediately available.
A liquidity fund, like a reserve fund, is a means for paying for expected bad debts, as well as for late payments, so that lenders receive their expected dues every day without interruption. Like a reserve fund, it's also for sharing the bad-debt load with other lenders, so that no-one suffers losses merely because they are unlucky with the borrowers they are lending to.
A liquidity fund differs from a reserve fund in that it's not funded with a large amount of money in advance. Instead, as much of the daily borrower payments as are needed are diverted into it to cover actual bad debts and late loans that occur that day.
In some cases, when actual bad debt has been lower than expected, the liquidity fund might receive higher payments that equal the expected amount of bad debt, in order to offset more losses in the future.
If bad debts are higher than expected, lenders can usually expect to see the interest they're earning come down, so that lenders are collectively pay for the additional amounts taken by the liquidity fund.
Especially for larger, more complicated property loans, such as short-term bridging loans, the process of attracting borrowers and assessing the documentation in loan applications is not usually called underwriting but “loan originations”.
Unlike underwriting of smaller loans that are approved or rejected automatically, there's usually more of a customer-service element offered to prospective property borrowers. This hand-holding is all part of originating loans.
Since these loans can't be processed automatically, the speed at which the peer-to-peer lending platform can manually process a loan is important to many borrowers. Originators need to ensure that good borrowers don't walk away before the process is complete.
Loan orginations often incorporates credit analysis as well.
People working as loan originators are sometimes financially incentivised to ensure that enough loans are completed, which can conflict with a duty of care to ensure high standards of loans.
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. Risks include:
- 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.)
- Particularly when combined with incompetence at the peer-to-peer lending platform (although it can happen to anyone) there's the risk that borrowers borrow fraudulently and run off with the money.
Mezzanine finance or mezzanine loans are a form of junior debt used in some property lending.
Mezzanine lending is always ranked the lowest, meaning that all other lenders to the same borrower – be they banks or anyone else – are ahead of the mezzanine lenders. Therefore, if the borrower is unable to repay, mezzanine lenders are the last in line to get their money back and the interest due to them. The exception is if the borrower also has unsecured lenders, which will take the back of the queue.
Usually, mezzanine finance is second charge, but it could be third charge or lower, depending on how many levels of loans are ahead of it.
This form of financing is usually used to fund property developments. It's sometimes also used to purchase a
development property or in bridging loans.
Depending on the precise contract with the borrower, mezzanine is often distinguished in another way: if the loan goes bad, it converts into part-ownership of the company that owns the property.
In practice, this shouldn't usually lead to worse – or better – outcomes in recovering bad debt versus an ordinary second-charge loan. But it depends on the competence of the peer-to-peer lending platform.
Sometimes, lenders are also allowed to choose to convert the loan into part-ownership even if the loan doesn't go bad. The contract might allow for lenders to do so after a period of time passes or even at will.
Moral hazard is a phrase that we borrow from the insurance world. It means behaviour that shows that the people involved at P2P lending companies might not be as focused on lenders' interests as you would like.
They might be taking too many risks or putting the growth of their companies above setting high lending standards. Or putting their own personal interests above providing lenders with accurate, up-to-date information on performance and future prospects.
A common sign of moral hazard in P2P lending is when a P2P lending company frequently refers to its own successful growth, its growth plans, its efforts to sell shares in its own business and so on. This warning sign is stronger when they also give less attention to a laser focus on patiently waiting for only high-quality loan applications to come in.
See loan originations.
P2P lending companies sometimes add negative-pledge clauses in the borrower contracts.
Through these clauses, borrowers agree not to give other lenders security that might reduce the amount of money that existing lenders would get back in the event the security needs to be sold to repay the debt.
Any new lenders would have to be placed in a more junior position, only getting any money back after the existing lenders are repaid in full, with interest.
If the existing lenders are not secured, the pledge might allow for the borrower to secure the existing lenders in a more senior position first, but only if the P2P lending company agrees.
Peer-to-peer lending is lending to borrowers through online and electronic lending platforms. If the platform in the middle goes out of business, there is zero or near zero risk that loan repayments can be diverted and used to pay the platform's own debts, such as money it owes to its own bank. Repayments due to lenders using the platform are ring-fenced against that scenario.
The platform itself, and any businesses that the platform owes money to, are not able to get their hands on lenders' money under any legal circumstances, especially if the platform goes bust.
To achieve this, lending contracts are either directly between the platform lenders and platform borrowers, or a legal means is used to get virtually the same level of minimal platform risk.
In legal terms, the three most common ways to achieve P2P lending status are:
- A direct contract is written between platform lenders and platform borrowers. This is most typically using a so-called “article 36H” agreement – or “P2P agreement”.
- A “deed of assignment” is used to transfer ownership of an outstanding loan and interest to platform lenders.
- A separate, “bankruptcy-remote company”, called an SPV, is set up. This is a company used purely to hold one or more loans for the benefit of platform lenders, with no trading or operations.
In each case, the platform in the middle does all the paperwork and administration on behalf of the lenders.
Whether a platform offers automated diversification or whether lenders select loans themselves is irrelevant. Both can function as peer-to-peer lending.
Not all IFISAs are peer-to-peer lending, so some IFISAs come with greater platform risk.
Note that “peer-to-peer lending” is not a regulated phrase
Some businesses call themselves P2P lending that do not meet the above definition. Others, choosing to market themselves differently, say they are not peer-to-peer, even though they do meet the definition above.
In practice, when genuine peer-to-peer lending platforms have closed, lenders have been receiving their repayments as expected.
Peer-to-peer lending is also called loan-based crowdfunding, social lending, democratised finance, marketplace lending and online direct lending.
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.
A personal loan is a loan to an individual, rather than a business. They are sometimes called “consumer loans”.
Usually, when a bank or peer-to-peer lending site says “personal loan” or “consumer loan”, it's referring to standard, unsecured personal loans of £100 to £25,000, available to borrowers who are deemed very likely to be able to repay.
These loans are typically repaid monthly and last from six months to five years. These are the sorts of loans you typically see advertised by banks.
Specialised personal loans tend to be called something else entirely, such as secured loans, payday loans or asset-backed loans.
In online or electronic lending, platform risk is the risk to lenders of losing money or interest due to loan repayments being diverted to cover the lending platform's own outstanding debts, or to pay for any additional costs of winding down existing loans if the platform goes out of business.
In peer-to-peer lending, P2P companies should not be able to use their money to pay their own debts. See the definition of peer-to-peer lending for more.
Property lending and property loans
Loans secured against real property (real estate) are called property loans. See security.
Refinancing is when a borrower already has a loan and then repays it by borrowing again. A borrower might seek to refinance through the same or a different provider.
In P2P lending, lenders already lending to a borrower can often choose whether you want to keep lending when the loan is refinanced, and you can decide again how much money they want to lend.
If the borrower seeks to refinance through the same provider, the borrower is usually assessed again. This means the loan application might be rejected, or the borrower might be offered different interest rates, or additional terms and conditions.
However, some P2P lending sites guarantee to borrowers that they'll be allowed to seek refinancing at the same interest rate from their lenders, provided the borrower meets all the outstanding interest payments.
Refinanced loans can serve a useful purpose for creditworthy borrowers and be lucrative for lenders, but it can also be a simple device for a P2P lending site to hide problem debts, because those debts can easily be rolled over many times.
Therefore, until a P2P lending site has established a long and successful record on such loans, lenders might consider staying clear of loans that are refinanced through the same P2P site; allow yourselves to be bought out by other lenders if a loan you're lending in is going to be refinanced.
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.
A resolution event is a phrase used by some P2P lending sites that have reserve funds, which are segregated pots of money set aside to cover lenders' expected bad debts.
In the event the fund is completely depleted, these P2P lending sites will call a resolution event, which means they'll pool all outstanding loans, so that they're shared between all lenders. This spreads the risk between all lenders and makes it much less likely that any of them will lose money.
Not all P2P lending sites with reserve funds are going to call resolution events.
Retail investor is a phrase used in the financial industry in the UK (and in many other countries) to officially describe ordinary investors. (Or ordinary lenders in the case of P2P.) Many people who lend through P2P are in this category of investor.
Retail investors are mostly expected to invest (or lend) in simpler types of investments that are typically not high risk.
In P2P lending, retail investors are often called “restricted investors” or “everyday investors”.
Businesses that sell investments that the financial regulator considers to be especially complicated or high risk must endeavour to exclude as many retail investors as possible from receiving any promotions and marketing. They must also ask investors to confirm their status and inform them not to invest at all if they are retail investors.
Peer-to-peer lending (including P2P lending IFISAs) is a unique case. Due to the relatively low risk and relative simplicity, retail investors are allowed. But because the P2P lending industry is so new, the P2P lending companies are required to get investors to earn a little bit of experience before they allow investors to lend freely.
Ordinary lenders in P2P are therefore initially capped at lending 10% of their investment pot. Lenders may swiftly promote themselves to a new category of investor after gaining a little P2P lending experience. They are no longer then retail investors as far as P2P lending is concerned, but rather “self-certified sophisticated investors”.
Further reading: Do “Sophisticated Investors” Have Less Legal Protection?
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”. (See “Junior debt”.)
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.
Compare with “first charge” and “personal guarantee”, and see also “fixed charge”.
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 or possessions 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.
Borrowers might be prohibited from selling security or taking any action that devalues it, which adds substantial protection for lenders. See fixed charge for more on that kind of security.
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” and “second 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.
Securitisation in P2P lending is when a P2P lending site packages more than one loan together and sells the whole lot to institutional lenders.
The deal might be the same, similar, better or worse than what individual lenders get online.
This is still not common in P2P lending, but it will happen more as P2P lending sites grow.
Self-certified sophisticated investor
Ordinary lenders (investors) can choose to self certify as sophisticated. In doing so, you're allowed to invest – or lend – in a wider variety of investments.
By self-certifying, you don't lose your usual legal protections against mis-sold investment or scams. It's usually very easy to self certify. This classifcation of investor is mostly to get you to think before lending, not to restrict you from lending.
The financial regulator keeps a tight grip on the definition of “sophisticated”:
Standard P2P lending/IFISA definition of self-certified sophisticated investor
There's a standard definition used by most peer-to-peer lending websites. Here, one of the following should apply:
- You've chosen and lent in more than one loan and/or lending account in the past two years. They can be from the same P2P lending/IFISA provider, but they need to be separate loan agreements (which they usually are) or portfolios of loans. This includes the provider that you are self-certifying for, if you have previously lent through it.
- You've worked in the provision of finance in the past two years, resulting in an understanding of the P2P agreements or portfolios you will be lending in through the specific P2P lending platform.
- You've been a member of a network or syndicate of business angels for at least the past six months.
- You've been a director of a company in the past two years with annual turnover of at least £1 million.
If you don't pass that definition when you start lending through a peer-to-peer lending website, you might pass it by the time you open the next lending account. So you might quickly be able to pass the test. Also, some peer-to-peer lending websites allow you to re-classify yourself as soon as you pass. This means you could, for example, lend in two loans (two loan agreements) through them and then reclassify.
Traditional P2P lending/IFISA definition of self-certified sophisticated investor
Some peer-to-peer lending platforms have adopted an older, more traditional definition, which makes it a little harder for lenders to self certify, because your prior P2P lending experience doesn't count.
In the traditional definition of a sophisticated investor who self certifies as such, you must have one of the following:
- Invested in more than one unlisted company (a company not on the stock market) during the past two years. This includes equity crowdfunding, which is buying shares in startups through online platforms.
- Been a member of a network or syndicate of business angels for at least the past six months.
- Have worked in the private equity sector or in the provision of finance for small businesses over the past two years.
- Been a director of a company in the past two years with annual turnover of at least £1 million.
Further reading: Do “Sophisticated Investors” Have Less Legal Protection?
A senior loan is ranked above other loans to the same borrower that are secured against the same property. This means that the loan will be repaid first in the event that the borrower has other debts that are ranked in a junior position.
Occasionally, 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.
Your prospects of recovering all your money are higher if you are in the senior lending position. However, a senior loan is more likely to suffer problems if the borrower is overstretched through too much junior debt.
See “First charge” for more.
An SPV or “special purpose vehicle” in peer-to-peer lending is a company that is set up exclusively to house a loan, or multiple loans, on behalf of lenders.
If set up correctly, it ring-fences the loans so that any repayments and interest due to be paid by borrowers can't be diverted to the peer-to-peer lending site, or to businesses that the P2P lending site owes money to.
For this reason, SPVs are known as “bankruptcy-remote entities”.
The SPV is not a trading company and has no other operations.
It's usually the P2P lending company that sets up SPVs to house loans, but sometimes it's the borrower itself.
Not all peer-to-peer lending sites use SPVs to ring-fence loans and instead use other legal means. Read more in our definition of peer-to-peer lending.
Stress testing is when an analyst takes the results of a peer-to-peer lending website's historical loans and extrapolates what might happen to those loans, or a similar batch of loans, in the event of a downturn.
A downturn could be a shrinking economy, a house price fall, rising unemployment or other similar scenarios that lead to more loans turning bad.
The 4thWay PLUS Ratings and 4thWay Risk Scores are calculated using a stricter version of the stress tests that banks around the world are required to do on their own outstanding loans, the so-called Basel tests.
Some loans – especially development loans – are typically approved in tranches. Developers need to demonstrate that they have spent their money and got through a phase of the project before the next tranche of money is raised. Sometimes, all the money is already raised at the start but drawn down in stages.
Underwriter and underwriters
An underwriter is a person who does underwriting.
Underwriters (always in the plural) are something else altogether. Underwriters can be a company or companies, or one or more wealthy people, who lend their money in so-called underwritten loans. Check out the definition of underwritten loans, as it doesn't mean a loan that's been reviewed by an underwriter.
Underwriting is checking the documents in a loan application and ascertaining what type of loan the borrower is most suited to.
Underwriting sometimes goes further into what's more appropriately called credit analysis. This is assessing the scale of risk the loan would pose.
For smaller loans, such as regular personal loans or small business loans, much or all of the underwriting process is often automated based on looking up data from credit-reference agencies and the electoral roll. In those cases, an underwriter will get involved when data can't be found or more information is required.
Underwriting can also refer to something else altogether, namely underwritten loans.
Underwritten loans in peer-to-peer lending is when a P2P lending site has partnered with one or more other financial businesses that lend their money, or their clients' money, first.
So, when you use that P2P lending site lend, the loan has already started. When you lend, you are actually buying loan parts from the partner company that lent to the borrower in the first place. You are still lending directly with the end borrower.
The reason for this is firstly to ensure that borrowers can get their money quickly if they need it. Secondly, it means there is a more stable supply of loans for you and other individual lenders, enabling you to lend more quickly. Finally, it means there is no waiting period where you earn no interest, because you don't have to wait until enough lenders pledge to take part before you can start lending to a prospective borrower.
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 when a loan actually does turn bad. Any lenders with secured loans will be able to recover their money first.
Contrary to popular belief, if a borrower stops paying an unsecured debt, the lender can easily get a court order on the borrower's property and possessions – if there are any. Then, whenever the property is eventually sold, the unsecured lenders will get their money back before the borrower is able to receive a penny from the sales.
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 court 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. This forces the borrower to sell, so that the lenders' wait to recover some or all of their lent money is shorter.
This second court 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, as an unsecured lender you will still be last in the queue behind any pre-existing secured lenders. And 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.
And, in the event of unsecured lending, there's no guarantee that the borrower has any substantial, solid property or possessions that can be sold on your behalf.
This doesn't make all unsecured lending bad – by any means. Some of the safest P2P lending you can do is to very high-quality borrowers, who often take out unsecured 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.
A wholesale warehouse facility is when the original lender in a batch of loans is lending largely with borrowed money through a credit facility or agreement specifically for that purpose. The entire facility is held in a bankruptcy-proof company called a Special Purpose Vehicle or SPV.
There are some typical features in warehouse lending. The facility is usually worth nine figures or more. The original lender will fund a portion of the loans with its own money and will lose their non-borrowed money first in loss events. And the loans are usually held in the warehouse until they can be sold through securitisation.
This can also be called “warehousing” or “monoline”.
Lenders using the online lending platform operated by RateSetter – formerly one of the biggest P2P lending platforms in the UK that has since been sold to Metro Bank – once took the position as wholesale lender in some loans before the regulator banned this form of P2P lending. However, while this was wholesale lending, it was not warehouse lending.