What is P2P lending? A good investment or a pyramid scheme? How does the business model of P2P lending works? There are many questions related to P2P lending, and for most people, it is also a new concept. However, P2P lending investments has been around since 2005. I am here to give a thorough explanation on what P2P lending is and how it works.
P2P lending is an investment type that allows investors to earn double-digit returns funding credit needs of individuals or businesses. Investors distribute their funds through P2P lending platforms and invest in loans issued by those platforms.
This post will uncover the mystery of P2P lending, and it works. The purpose is to inform you about how P2P lending works, what you can expect as a P2P lending investor and the advantages and disadvantages.
What is P2P Lending?
To many people, this is a new concept even though it has been around for many years. P2P loans is a way individuals or businesses can get credits from other individuals. P2P lending is, therefore, a financial alternative to banks.
Websites, known as P2P lending platforms, act as middlemen providing loans to individuals and businesses. The loans published on the P2P lending platforms gets funded by the investors’ money. P2P lending platform is advocated to have a lower overhead cost and offering their services cheaper than the banking alternatives. This makes the investor eligible for higher returns than the traditional savings account, even though a bank and a P2P lending platform mostly work the same way.
Another easy way to interpret P2P lending from traditional banking is that P2P lending is small sums from a lot of sources, and conventional banking is large sums from one or a few sources.
Traditionally you use a bank to get a loan. When banks approve loans, the money used to fund the loans is deposits from other customers. This means that the banks earn interest on your bank accounts, where you only get sub-1% interest. However, P2P lending lets investors fund loans directly to the borrowers for a high-interest rate.
P2P lending is typically done through investment platforms and therefore, they can provide loan agreements. This enables the investor to have a legal claim towards the borrower, even if the platform goes bankrupt. These platforms act as an intermediate between borrowers or loan originators and the investors. The loan originators and the platforms are advocated to have lower costs than banks. This will make both the investor and the borrower benefit from P2P lending. Furthermore, the investor has the ability to choose which loans they want to invest in.
The typical picture presented will be having the investors on one side and borrowers on the opposite side with the P2P lending platform in the middle. Mintos P2P lending platform presents it in the following picture:
While Mintos has one way of showing their version of how P2P lending works, the European Commission has another way of visualising it. The European Commission has taken the side of business-oriented P2P lending.
P2P lending is believed to be a way to fund businesses before they reach a financially stable balance sheet according to the European Commission.
Liquidity is not as easy to get as, e.g. with stocks. Some P2P lending platforms offers what is called a secondary market. This is a loan book with loans that investors which to exit. A platform such a Mintos and Estateguru has a secondary market where the investors can sell their shares in a loan to other investors. The selling of a loan can be done at a discount or premium. The price of a loan on the secondary market is typically a reflection of how desperate an investor is, or how reputable the loan originator is.
However, not all platforms offers secondary markets. This means that when the investor has committed to a loan, they have to hold it to maturity.
Acronyms of P2P lending:
- P2P lending
- Peer-to-peer lending
- P2B lending
- Peer-to-business lending
- Equity crowdfunding
- Reward-based Lending
Who Are The Lenders?
Interested in making money? Interested in making a return bigger than the average stock index? Well, P2P lending seems to be the place for you. P2P lending is for everyone willing to invest in loans. Typically it is the speculative investor, due the history of P2P lending.
P2P lending is a relatively new investment type compared to other investment types such as the stock market, Certificate of Deposits (CDs), bonds, etc. and therefore, it is also riskier.
The lenders are investors who are looking for alternative investments. Typically, it is possible to find dividend investing bloggers who are attracted to P2P lending, or vice versa. It can, therefore, be assumed that the typical P2P lending investor is a cash flow investor.
Who Are The Borrowers?
The lenders drawn to P2P issued loans are borrowers who can bargain on loans compared to what is offered at a bank or credit union. This could be for mortgages, business loans, consumer loan, etc. Due to their lower costs, the P2P lending platforms might be able to undercut banks and credit unions.
The borrower could also be one that cant acquire loans at a bank. This can happen for various reasons. One is that a business that has yet gotten a stable cash flow, e.g. a start-up, can’t get a loan from a bank. However, if enough investors think the start-up’s project/business is good, they can get funding through a P2P lending platform.
The problem for many start-ups and small businesses is that banks are conservative and want years or signs of positive cash flow. Typically start-ups and small businesses cant give statements with positive cash flow.
P2P Lending Business Model
How do the P2P lending platforms make money? how do they make money? P2P lending is a simple business model. The P2P lending platform has a fee charged for the loan originator or borrower. The borrower and/or loan originator pays for the fees associated with lending, and therefore the investors can invest mostly fee-free.
One of the few platforms that disclose how they make their income is Estateguru. Estateguru issues their financial statements (can be found in the footer of their page here). In the financial statement under note 6, it can be seen that they have “loan success fee”, “administration fee” and “other revenue”.
In simple terms, the P2P lending platforms makes money when the loan originators or borrowers are issued loans through the P2P lending platform.
Traditional P2P Lending
Traditional P2P lending is the act of lending to a borrower with only the P2P lending platform as an intermediate. This type of lending is most common by platforms that issue loans through their own subsidiaries or business lending platform.
The platforms with direct lending is platforms who do the due diligence process for the investor and publishes the information. The investor can then make their due diligence based on the information provided by the platform.
In contrast, the P2P lending platforms with subsidiary lending rarely provides any information about the borrowers. The investors, therefore, has to trust that the borrower will repay or that the platform will cover the potential losses.
P2P Lending Platforms With Direct Lending:
P2P Lending Platforms With Indirect Subsidiary Lending:
The traditional P2P lending methods is connecting investors directly to their borrowers, either through an owned subsidiary or a borrower that approached the platform for funds. In other words, the borrower and investor is only one link from each other, being the P2P lending platform.
Third-Party P2P Lending
In contrast, the third-party P2P lending is with a loan originator involved. The loan originator is an intermediate of the borrower and P2P lending platform. The intermediate is known as loan originators.
The loan originators are credit unions or loan agencies. The loan originators can post loans on P2P lending platforms and have investors fund the loans. In essence, the loan originators can fund many more loans. This is due to the “skin-in-the-game” factor.
A loan originator is asked to put at least 5%-15% skin in the game. Skin in the game is a term used for how many percentage of a loan the loan originator is obligated to own. Therefore, if the loan originator issues a loan of €100 and have a skin in the game of 15%, the loan originator must hold €15 of the loan.
Since the loan originators only has to fund 5%-15% of the loans themselves, they can use 85%-95% of their funds to acquire new loans. This means that the loan originators becomes a lot more leverage, and hence the loans are a lot riskier.
P2P Lending Platforms With Loan Originators:
There is various types of loans issued in P2P lending. Any loan type that you can think of is probably issued through P2P lending platforms. Just to give a brief overview of the most commonly found loan types in P2P lending here is a list:
- Consumer loans
- Bridge loans
- Invoice financing
- Business loans
- Development loans
- Real estate purchases
- Car loans
- Pawnshop loans
The loan type will also reflect the returns that is offered to the investors for funding the loans. Typically real estate purchases is offering low returns compared to funding of business loans. This is due to the simple fact that real estate only fluctuates in value, and it pays a monthly rental income, whereas businesses can go bankrupt. Mainly companies in the start-up phase are exposed to financial instability, and hence insolvency is a more likely scenario.
P2P lending is known for the increased risk. Hence the returns are often double-digit. It is easy to get an interest rate of 15% if you are willing to take the risk. However, to minimise these risks, the P2P lending platforms has tried to make initiatives to make the investments safer for the investors.
So how is the investments secured for the investors?
Skin in the game: Skin in the game is a term used to give the investor an indication of how much the loan originator owns of an offered loan. If a loan originator has a skin in the game of 10%, they must own 10% of the full loan amount.
Buyback Guarantees: Buyback guarantees is an obligation put in the loan originator by the platform. The buyback guarantee is a security that the loan originator will repurchase the loan if the borrower defaults. Hence, the investor does not lose any funds.
However, a common misconception is that whenever an investment is offered with a buyback guarantee, the investment becomes risk-free. This is not true. If the issuing loan originator has financial difficulties, they might not have the funds to repurchase the defaulting loans. Hence the investor will lose their money. In simpler words, the buyback guarantee is only as good as the loan originators financial health.
Buyback Funds: Another initiative made to cover the investors is a buyback fund. The idea is the same as the buyback guarantee. However, the buyback fund is funded by a small percentage of successful repaid loans. Over time the buyback fund will increase, and will be able to cover more significant losses. However, the buy fund can only cover whatever the size of the fund, hence local or global financial stress will drain such buyback funds quickly.
Collateral: The last security is collateral. Collateral is known from traditional loans. A bank can in exchange for credit have pledged collateral on a property. This is a security for the bank that the borrower will repay the loan. Otherwise, the bank will take the property and sell it to recover their loan.
I have written a post covering buyback guarantees and collateral, which goes into more detail.
Expected Returns With P2P Lending Investments
The expected return on investments vary on a lot of things and cant be put in a formula. However, using a compounding calculator is the best option we have to estimate what our money will be worth in the future.
The double-digit returns made from P2P lending can significantly boost the rate at which money multiples. The difference between a bond with a gain of 4% is substantially different from a loans with interest rates of 12%. Try playing with the compound return calculator.
While the calculator estimates a one time deposit and a constant growth with no losses, the returns are clearly different from the different investment types.
Looking into other investment types, P2P lending could easily be very lucrative. Furthermore, P2P lending doesn’t work as other retail investments. For example, stocks fluctuate in price. However, they average about 9%.
While comparing P2P lending to other asset classes can be dangerous as the history of P2P lending is limited, one could speculate that it currently was the most lucrative investment.
When looking into the correlation between other asset classes, P2P lending seems to be rowing its own boat. Completely independently of different investment types. Using the correlation matrix below it can be seen that there is a very little correlation between stocks, real estate, bonds against P2P lending.
The closer two asset classes are to 1, the closer they correlate. The biggest correlation P2P lending has is the US stock market.
My Experience Using P2P Lending
My overall experience using P2P lending is positive. However, being a bit too naive has gotten me into some losses with untrustful platforms. The losses occurred as a result of a lack of transparency by the platforms and too naive investors. The investors funded fake projects, and then the executives of the platforms ran away with the money, very unfortunate.
With that being said, the trustworthy platforms such as Mintos and Estateguru has delivered the promised. A lot of transparency makes the trustworthiness of the platforms seem genuine and more accepted by the broad community.
While the overall loss is about €1.500, continuous investments and sticking to a long-term plan at trustworthy platforms should restore the lost funds. This is also an example that buyback guarantees will not save your money.
You can follow exact earned every month in the monthly portfolio updates.
P2P Lending Advantages and Disadvantages
There is some clear advantages and disadvantages of using P2P lending, both as an investor and as a borrower.
- Higher returns than traditional investment types
- Typically fee-free investing
- High diversification between industries and amount of loans
- More accessible way of funding
- The current legislation is vague/non-existing
- Credit risk
- Currency risk
The advantages more or less speak for themselves. You get a higher return than if you go for stocks, real estate, etc. Furthermore, P2P lending platforms typically offers free investing for investors. However, the borrowers pay the fee when acquiring a loan, just like when obtaining a loan through the bank.
With the low costs, investors are also able to heavy diversify across multiple loans. The platforms offer loans within development projects, mortgage loans, personal loans, business loans and much more. If the same diversification where to be done with stocks, the fees would have eaten a lot of profits.
Unfortunately, there are disadvantages of P2P lending. One is that the current legislation is very limited to either the anti-laundering policy or a total ban from authorities.
Furthermore, there is a chance that the borrower will default and your investment is lost. However, as risk mitigation, some platforms offer buyback guarantees. These buyback guarantees are typically provided through the loan originators. Therefore, if a loan originator goes bankrupt, the buyback guarantee will be worth nothing, and your funds will be lost.
Is P2P Lending Safe?
There are always risks when investing. People are fearful of P2P lending because it is a new type of investing compared to the traditional stock picking, index funds, and real estate. However, P2P lending is only as risky as you make it. The P2P lending platforms have done a lot of mitigation to secure the investors.
P2P lending platforms are not interested in bad borrowers. If they get poor loan originators or lend to the wrong people, the platforms are not making any money either.
There are generally seven risks to consider when/before investing in P2P lending. It is not hard to mitigate, and it is fairly easy to follow:
- Platform diversity
- Loan originators/borrower
- Understand the platforms
- Financial state of the platforms
- Regulation and legislation
- Haven’t experienced a recession
- Psychological risk (You are a risk)
One risk that is easy to relate to is diversification of investments. You might have heard the phrase “Never but all your eggs in one basket”. This is true no matter what you invest in. When diversifying, it is important to diversify not only across loans but also on different platforms.
Closely related to platform diversity is the loan originators. While it is important to diversity across loan originators, it is also important to evaluate loan originators. The loan originators might have been assessed by the P2P lending platform. A platform known for doing this is Mintos. However, some platforms are acting as loan originators as well. While a platform like Mintos is intermediate from borrowers to investors, platforms like Crowdestor is lending to borrowers themselves through their platform instead of using loan originators.
Understanding the Platforms
The different platforms in Europe all have diverse strategies and ways of working. Therefore, it is important that you understand the platforms you are investing with. If you have invested in loans with buyback guarantee on, e.g. Mintos or Lendermarket, you will get your funds back if the borrower defaults on the loan. However, if the borrowers default on a platform like Crowdestor, you will have to accept the full loss of your funds.
Another thing you need to understand is the currency which the platform operates. The best explanation here is an example. A loan originator has issued a loan in Russian rubles, the loan originator gets the loan funded in Euro, and it has to be repaid in Euro. The borrower will repay with Rubles, and the loan originator will convert it from Rubles to Euro and pay the investor. But what does the loan originator do when the ruble has lost 15% value against the Euro?
Financial State of the Platform
A very underestimated step of risk assessments is the financial state of the platforms. If a platform does bankrupt, you can be exposed to financial losses as well. Again, it is important to understand how the platforms are put together. Using Mintos as an example: the loan originators are liable for the loans even if Mintos goes bust. Mintos will only act as an intermediate from the loan originators to the investors.
Regulation and Legislation
Knowing the legislation will help you a great deal. For example, the UK suddenly banned P2P lending for investors due to the risk they are exposed to through P2P lending. The UK authorities would like to develop some legislation to regulate the P2P lending industry. The UK authorities have discovered some risks towards the investors, and to protect the UK investors they have banned P2P lending until further notice. If your region were to make such regulations, you should act and comply with the regulation.
Haven’t Experienced a Recession
The platforms LendingClub and Prosper are the only platforms old enough to have been through a recession. They were both in the 2008 recession. New platforms are emerging all the time, while the older platforms are expanding. Therefore, the P2P lending industry could be inflating and collapse in the next recession.
Psychological Risks (You are a Liability)
The last risk there is, is you. If you get greedy or fearful, you are exposed to the same risks as when investing in stocks. Let us take an example of both. If you are fearful, you are investing in loans that are expected to be very safe. However, these loans are also the once which, provides the low returns. The opposite is true if you are greedy and go for the highest possible returns. This also bears the highest amount of risks.
You can read a more in-depth of P2P lending risks and ways to mitigate the risks in my 7 risks of P2P lending article.
If you are already a registered investor on Mintos, you can read my post on how to achieve high returns while having a low risk on my Mintos Auto-invest Strategy post.
Through this post, I have highlighted some of the essential topics related to P2P lending:
- What is P2P lending?
- How does P2P lending works?
- P2P lending advantages disadvantages
- Is P2P lending safe?
- Best P2P lending platforms for Beginners
P2P lending is a way for small businesses and individuals to lend money at a cheaper rate than banks can offer. Furthermore, there are P2P lending platforms in place which works as an intermediate for the borrower and the investor. The P2P lending principle is followed with many benefits. However, there are also a few disadvantages. For the investor, there are typically no costs associated with investing, and the returns are considered better than other investment types.
P2P lending is, for now, considered a risky investment. However, there are ways to mitigate risk.
Frequently Asked Questions About P2P Lending
Is P2P Lending Safe?
No investment is ever safe. The process of P2P lending is secure. P2P lending can be as safe as you want it. If you only go for the high-interest loans, you are exposed to higher risk. P2P lending is what you make. Hence if you invest smart, you can be relatively safe.
What is the advantages of P2P lending?
P2P lending generates a stable return in the double digits. P2P lending can be as safe as you make it. There is often no fees or commissions investing in P2P lending.
What is the disadvantages of P2P lending?
P2P lending is a new FinTech innovation. The industry has not yet seen recessions to test the stability of the P2P lending market. Furthermore, a couple of P2P lending platforms from the Baltic region has run away with the investors’ money.