The saying goes – “The higher the return, the higher the risk”. P2P lending is a place where you can easily bring in 10%+ per year. Furthermore, it is very often a passive investment form compared to other investment types. P2P lending is a newer incentive for investing. Therefore, there are increased risks when investing in P2P lending platforms. There are a lot of P2P lending platforms, and new platforms are emerging rapidly. More so, there are only two platforms old enough to have experienced a recession (2007-2008). While P2P lending is considered a risky investment knowing the risks associated with P2P lending will help you mitigate the risks when investing.
The Risks of Investing in P2P Lending
To get a better understanding of the risks involved, you should consider the 7 risks of investing in P2P lending:
- Platform diversity
- Loan originators/borrower
- Understand the platforms
- The financial state of the platforms
- Regulation and legislation
- Haven’t experienced a recession
- Psychological risk (You are a risk)
1 – Platform Diversity
The first and maybe the most obvious risk is not diversifying across multiple platforms. Platform diversification is necessary if you want to have a healthy P2P lending portfolio. The amount of the aspects in relation to P2P lending platforms is humongous and therefore you should consider each platform and their attributes.
A platform like Mintos is the biggest P2P lending platform in Europe, they have average returns (compared to other platforms) and deliver diversification among thousands of loans. A platform like Crowdestor has little diversification however they provide above-average returns.
2 – Loan Originators/Borrowers
Continuing from the first risk, P2P lending is a mean for small businesses and individuals to lend money. Even more so, the European Commission has opted for an opinion on future legislation. The European Commission acknowledges the opportunity for small businesses to raise capital through P2P lending. Whereas normally small businesses had to put down a lot of equity, sell shares of the company to investors, or find other ways to raise capital. You can read more about the European Commission’s opinion here.
There is a “myth” within the P2P lending community that goes: “People that cannot get approved for bank loans will just go apply on P2P lending platforms and get approved.”
While I cannot invalidate the statement, I think that you should conduct your own due diligence before investing in a certain platform. With over a year of investing in different P2P lending platforms, I have not experienced a borrower or a loan originator which could not repay. In other terms, I have so far not lost any money on P2P lending platforms.
What makes P2P lending platforms unhealthy for the borrowers is when they cannot repay their loans, so they have to take out new loans to pay the first loan. This is criticized for being unethical as the investors help to fund such activities. This can also turn out to be a major risk if more and more borrowers are unable to repay their loans and therefore take out new loans when trying to pay off the first loans.
3 – Understanding the Platforms
The second risk brings me to the third risk. Understanding the platforms. There is a big difference in how the platform’s obligations are to the investors. On a platform like Mintos or Estateguru, the loan originators are required to buy back defaulted loans, while on a platform like Crowdestor there are no guarantees if the borrower cannot repay their loan.
Therefore, understanding how each platform works is essential to the capital you have at risk.
4 – Financial State of the Platforms
The financial state of the platforms is often overlooked. While I cannot blame investors as the platforms are generally really poor at publishing their financial statements. However, as an investor, you must know the basic financials to properly manage the risks.
While you cannot expect the smaller platforms to generate massive amounts of profits. A P2P lending platform’s financial statement tells something about how they as a company manage their money and assets.
In industry 4.0, FinTech companies are evolving quickly. P2P lending is under the category of FinTech, and in every industrial revolution, it is followed by a collapse. Therefore, ensuring proper asset management by the P2P lending platform is good risk mitigation.
5 – Regulation in the Future
Currently, in the European market, there is little to no regulation on P2P lending. While the European Union is working on different proposals (like the one I cover from the European Commissions proposal), there is no direct regulation to P2P lending. However, within the European Union, the legislation is basically the anti-money-laundering policies and accompanying the transfer of funds.
The anti-money-laundering policies affect both the investors and the P2P lending platforms. The investors have to verify on the platforms with national or international identification.
With a young industry, there is no telling or clear prediction of how the regulation will roll out in the future. Furthermore, it is hard to predict how you as an investor will be affected. Therefore, following the legislative authorities in your region can help you act quickly to changes concerning you.
6 – Haven’t Experienced A Recession
When a recession hits, there is no telling where P2P lending is going. The only P2P lending platforms that have been through a recession is Lendingclub and Prosper. Furthermore, they are both American platforms. When a recession occurs again it might be different for both the European and Asian Platforms.
The picture illustrated below is from Lendingclub in the period of start 2007 to the end of 2009. Looking in the two last columns the interest rates are stated. The average interest rate where more or less like they are today (not in a recession). However, the adjusted return is significantly lower. However, notice that not even their most risky category “FG” is losing money.
Explanation to picture: Total issued is the amount issued to loans. Fully paid is the principal repaid. Principal payments received is the including the charge off. Interest payments received is the collected interest including future charge off. Therefore, to calculate the actual amount made is the principal payments received + interest payments received – charge off (net).
In essence, this means that even the riskier loans will generate some income, while there will be many defaults.
While it is unclear when and how bad a recession will be, it is also unclear how each P2P lending platform will handle a recession.
7 – Psychological Risk (You Are A Risk)
While P2P lending is a more passive investment strategy compared to other investment types like stock picking, there are psychological risks involved.
Greed and fear are big psychological risks for investors.
Greed is dangerous within P2P lending. Finding a platform which can generate 18%+ returns is not that hard, however they usually come with the costs of monetary safety if the borrower defaults. Platforms such as Bulkestate, Crowdestate, and Crowdestor all have the possibility to reach above 15% returns. However, on all 3 platforms, there is no buyback guarantee if the borrower defaults. This is where platforms like Mintos and Estateguru is good. They provide a lower return, but you are most likely in a safer spot with your invested money.
Fear is just as dangerous. If you have been greedy and invested only in high yielding platforms with no diversification and lost some money due to defaults, you might have withdrawn your money to save yourself from further losses. However, like stocks when the price goes down, do not panic and keep sticking to your strategy.
While it can hurt to see defaults the smartest thing is to analyze why you have defaults. This brings me to a follow-up question on how to reduce risks when investing in P2P lending.
4 Ways to Reduce Risks in P2P Lending
The risks of investing in P2P lending has been mentioned above. To briefly sum up the topics: You should diversify across platforms, know the loan originators/borrowers, understand the P2P lending platforms, investigate the financial state of the P2P lending platforms, stay up to date on regulations as this is a newer and less regulated industry, stick to your strategy even in a recession and do not become greedy or fearful, find a balance.
The 4 ways to reducing risks in P2P lending are, therefore, mitigating all of the above-mentioned risks.
1 – Make an Investment Strategy to Mitigate Risks
In stock investing, there is a term called “dollar-cost averaging”. In essence, this means that you consistently purchase shares of a company you have long term prospects with. No matter if the stock is increasing 100% per day, or decreasing 80% per day, you consistently purchase the stock. The same “dollar cost averaging” can be used when investing with P2P lending.
Every month you get income from your day job, you deposit an allocation such as 65/20/15 between Mintos, Estateguru and Crowdestor, respectively. This way you have the highest exposure on the biggest and safest platform, and the lower exposure on smaller platforms with higher returns.
2 – Follow Your National or Regional Regulators
While you should not get a lawyer degree within P2P lending, you should regularly follow up on any legislative rules, open meetings, etc that you can find in your legislative district. New regulation can impact the strategy you are using. This could be anything from taxes to the use of cross-border P2P lending platforms.
3 – Understanding the Platforms
As a follow up on the understanding regulations, understanding the platforms is essential to minimize risks. A good example of the differences between platforms is the P2P lending platform called Viainvest. Viainvest is a P2P lending platform like most other platforms. However, Viainvest withholds taxes from your income (made in specific countries). A platform like Mintos does not withhold investors’ income to taxes. However, Viainvest states that they interpret the legislation from certain countries, making them obligated to make such actions. Another blogger from the P2P lending community has kept away from Viainvest. He simply does not want the go through the hassle. You can read his reasoning here.
This is an example of a mismatch in the interpretation from the different platforms. Therefore, understanding the legislation and regulation will help you to know how to tackle such challenges. Furthermore, whether or not you want to invest in such platforms.
4 – Keep Your Head in the Game
Getting into emotional distress is quite easy when you see your investment accounts decrease in value. However, just like stocks the value of your P2P lending accounts can decrease.
To keep your head in the game it is important not to get greedy or fearful. This will require some discipline. Jumping all in with your entire savings account when a new project yielding 22% becomes available is a very bad idea. That is not to say you should not try to benefit from such a situation. However, you should consider investing a small percentage of your overall portfolio rather than going all in.
The same goes for being fearful. If you only invest in the biggest platform in the safest loans, you will most likely experience a 5%-6% return. While such a return is not bad compared to other investment types, it is possible to reach higher returns. Furthermore, if you experience a default you should not fearfully withdraw all your money from the platform. That is how P2P lending works, from time to time you will experience a loss.
Risks of P2P Lending – Conclusion
There are many risks of investing in P2P lending. However, there are also many ways to mitigate such risks if you are willing to put in a little bit of work. It is not a difficult task to reduce the overall risks.
Based on the 7 risks of investing in P2P lending there are some main topics to be aware of when starting out in P2P lending. However, whenever you get started most of the risks become a habit in adjusting to. However, make sure you follow all 7 risks and evaluate your portfolio. Furthermore, you should consider if you follow the 4 ways to reducing your P2P lending risks.
Overall, it is not difficult to mitigate the risk and acquire good returns. Personally I achieve between 12% and up to 20% and have not yet experienced a defaulted loan which was not repaid to me. You can follow my income from my monthly updates.