Investing isn’t for rich people only anymore. We live in exciting times where everyone can participate and call himself an investor. And if you’re a tech savvy person who’s consistently trying to find new opportunities for your money to work for you, you definitely heard about the peer-to-peer lending market.
Even though the P2P lending as we know it today is initially the consequence of the last financial crisis between 2007 – 2010 as a result of the reluctance of banks to issue new loans to consumers and business, the market really hit it off in last few years. From immaterial market share, which didn’t bother bank representatives at all (they probably didn’t even hear about it), we can read about the exponential growth of the market in the last period with predictions that the total share of P2P lending could be the dominant force in the personal loans market by 2025.
Indeed, if it’s growing, it might be a great investment opportunity. And where are the investors demanding easy access to this market, businesses are emerging to supply the services to those investors. This brings us to the crucial need to differentiate between key terms in our P2P involvement as investors, who would like to participate in this fast-growing market.
Traditional Peer-To-Peer Lending
When someone is talking about growing P2P lending market, this usually stands for a relatively simple business model where the online platform provides a low cost standardized loan application process and facilitates direct matching of borrowers and investors. Your position here as the investor is the lender. You are reviewing loan opportunities on the website (after some verification of the borrower by the platform) and you decide whether he’s able to pay you back and whether he offers interest rate which matches the perceived risk. In this case, the platform is the loan originator and acts also as an agent for the investors by servicing the loan in return for related fees.
The platform maintains records, collects borrower repayments, distributes cash to you and other lenders and manages the recovery of bad debt. Fees incurred are usually percentage of interest repayments but registration fees are common as well. Investors’ main risk under this model is the credit risk towards borrowers.
“P2P” Loans Marketplace
In the last 3 years, lot of platforms emerged offering the services of so called P2P investing. In traditional P2P lending, online platform had a role of the loan originator and lender’s agent. Thus, in business relationship there were 3 parties – platform, you as an investor and a borrower.
What is generally understood under P2P investing is, that there is another party which is the separate loan originator. The platform is only intermediary between you as an investor and loan originator, which is the company who provides different types of loans to individual borrowers or business.
Even though it looks similar, small differences do matter very much. The different business scheme means different risks for you as an investor. Under the first model, your main risk was the credit risk of a loss resulting from a borrower’s failure to repay a loan. In case when the borrower is unable to repay a loan and platform serving as an agent is unable to recover the principal in full amount, you have to write-off your receivable towards borrower and thus, you suffer a loss.
In the second model, under normal circumstances, you would be exposed to two different credit risks – towards borrowers and towards loan originator. To compensate for such risk almost all the main platforms in “P2P” investing offer so called “buy back guarantee”. This became one of the most important terms in this market and it stands for a situation if repayment of a particular loan in which you invested is delayed by more than a specified number of days (usually 60). Then the loan originator is obligated to buy back the principal of the loan from you. This looks like a win win situation – higher return, lower risk.
Should I Switch My Retirement Savings to “P2P” Investing Then?
Well, probably not because let’s be realistic. If someone offers you 12% p.a. and more and buy back guarantee on top of that, your common sense of reasonable investor should tell you that there might be a catch. And there most definitely is. The catch is the effective meaning of buy back guarantee which transfer all the credit risk from a borrower to the loan originator. If the loan originator goes bankrupt, the buyback guarantee is worthless. Not even bankruptcy has to occur as the Aforti case on Mintos and Viventor platforms showed us.
In the end you are not investing in P2P loans, but you are providing capital to loan originators. You always have to keep this in mind. The reason why loan originators are even using loan marketplace platforms in the first place is to get capital to grow their business by having funds to provide more and more loans. Their business is risky, venture capitalists want board seats and/or shares in the equity and bonds might be even more expensive. Or the loan originator simply doesn’t want more regulatory scrutiny after he would become a public interest entity after the issuance of publicly traded bonds.
I’ll explain in more detail. Your risk towards a borrower as an investor in “P2P” loan marketplace is only of not receiving interest. When borrowers are late with their payments, your risk is only the amount of interest you lost. Your principal is at risk if loan originator will have financial problems. This means that the loan marketplace is a clever scheme for loan originators to obtain financing with variable interest rate fluctuating based on loan performance. If the loan is not performing, they don’t have to pay you any interest. If the loan is performing, they have to pay you, but they receive much more from a borrower in return. And that is a win win situation for loan originator.
There are some examples of loan originators on some platforms which pay you the interest also for delayed payment. In their case the interest is not variable, but fixed. In this case, all credit risk is effectively transferred to loan originator as it doesn’t matter whether a borrower will pay the money back or not as you’re getting the compensation from loan originator regardless of the payment discipline of a borrower.
Is “P2P” Investing a Scam?
Not at all. But it seems that it’s generally considered as something it’s not. Always try to understand the relationship between risk and reward. People usually spend a few weeks or months analyzing the possible rewards without even considering the risks. And then they are surprised when some problems occur.
Anyway, I would be really cautious regarding buy back guarantee. This is in the “P2P” community sometimes perceived as the ultimate assurance for investors. But if you take a closer look, this is just a promise to pay your money back if it hasn’t been paid for 60 days. Compared to other collateral options, this is basically nothing. Your position would be the same as the position of ordinary suppliers in case of bankruptcy proceedings. Try to invest in loan originators which provide additional guarantee on top of a buy back promise.
There are so many platforms out there currently so the chances that some of them might turn out to be scams are high. Maybe they were not exposed yet, but be aware of the complications which might happen and invest only in trusted sites with a history of at least a few years.
How Do “P2P” Loan Marketplace Platforms Earn Money
Loan Marketplace platforms don’t generally charge any fees to investors except for foreign currency translation fees in case they offer loans denominated in other currencies as well.
Main source of income of some kind of service fee charged to loan originators so their loans can be listed on the website. Such fee is tied to the volume of loans so the biggest loan originators pay the highest fees. This keeps platforms motivated to list as many loans as possible and to gain new loan originators as well.
The financial performance of such marketplaces is usually at break-even or loss making due to investor acquisition costs such as marketing expenses and sign-up bonuses. Long-term plan is to attract that many investors so they’re an attractive platform for as many loan originators as possible and to reduce marketing expenses after that.
The main message of this article is to distinguish between P2P lending and loan marketplace platforms. Even though it might seem similar and indeed some platforms are really trying that it looks virtually the same, by understanding the business model we can conclude that the risks are a lot different.
Personally, I don’t consider loan marketplaces to be related to P2P industry rather than P2B (where individuals have the opportunity to lend to established businesses) due to risks involved. And therefore, this might be an interesting opportunity for investors who would like to invest in the consumer financing industry through a variable (or fixed) interest loan.
I’m invested in loan marketplaces platforms for about 1 year now. Currently I’m in the position of slowly withdrawing my funds and keeping only some exposure towards the most reputable loan originators without shady practices such as exploiting grace periods, principal buy back in case of performing loans, with additional assurance on top of buy back guarantee and without any previous problems. And as you can imagine, there is a current shortage of those.
My recommendation would be to do an extensive due diligence about the platform you want to invest and about each loan originator separately before you loan him your money. The industry is unregulated and problems will definitely occur, it’s just a matter of time. Only the best platforms will be able to survive them. So make sure that your money is at the best possible place at all times.