Peer-to-Peer Lending And IFISA Glossary
This is our glossary of terms, giving you all 4thWay's peer-to-peer lending and IFISA definitions.
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.
Assets and asset-backed lending
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.
A bridging loan is a short-term loan secured against property. (See “Secured lending and security”, below.)
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.
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, so that the 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 and it is “drawn down” in stages.
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. It includes first and second charges. 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.
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.
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 stands for Innovative Finance Individual Savings Account, but despite the word “savings”, lending is actually a form of investment.)
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.
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.
Especially for larger, more complicated property loans, such as short-term bridging loans, the process of attracting borrowers and assessing loan applications is not usually called underwriting but “originations”.
Assessing the risk of these sorts of loans, and the worthiness of the borrower, can be trickier than many other kinds of loans.
Loan originators are sometimes incentivised to ensure that enough loans are completed, which can conflict with a duty of care to ensure high standards.
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.)
See Loan originations.
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.
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.
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”. (See “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.
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 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.
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.
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.
Underwriting is looking at all the facts in a systematic way, based on set criteria, to decide whether a loan application should be approved, and at what interest rate.
For smaller loans, such as regular personal loans or small business loans, much or all of the 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 sometimes be more of a qualitative assessment, which is especially the case for larger, more complicated property loans, such as short-term bridging loans. See Loan originations.
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.
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.