P2P Lending is a recurring topic in the Financial Independence community due to its relatively good track record (at least in Europe in the last couple of years). After losses, investors are regularly above 10% return per annum—an incredible performance compared to other alternatives in Europe.
Discussions I’ve had on the topic highlighted how investors often underestimate some of the potential problems with P2P Lending. This article is mainly a reference for myself, and others will hopefully find it helpful too. I’m focusing only on the negative as I’m the type of person who likes to talk about the bad news before the good news. Nevertheless, I believe P2P Lending has its place in some EU investors’ portfolios, and I’m allocating some funds to it.
Here are the main risks and challenges I think one should have in mind before investing.
1. Lender risk
The easiest to think of: If a borrower can’t repay, what is the process to recover your capital and potentially the interests? This changes based on the platform, and in practice, you’ll never do the collection yourself. Although I heard of cases where the platform explains having failed the debt collection and then sends the borrower’s info to the lender.
The success of the collection process will be influenced by the collateral for the loan, although you can also invest in unsecured loans (meaning there isn’t any collateral).
I find that taking time to analyze and manually invest rarely makes financial sense. A very broad diversification across hundreds of loans is a good alternative.
Identify who will do the collection process and analyze their track record.
2. Loan Originator risk
Loan Originators (LOs) are the ones interacting with the borrowers. They collect interests and usually organize the collection in case the borrower fails to repay on time.
As they are just another type of business, they can go bankrupt. At that point, getting your capital back becomes challenging: Lenders are still liable, but the disorganization can lead to some or all of your money being lost.
Loan Originators often offer “Buyback Guarantees” on platforms such as Mintos. This means you’ll be able to find loans with returns nearing 20% with your capital guaranteed in case the borrower can’t repay. Sounds too good to be true? Of course, there’s a catch: If too many lenders fail to repay at the same time (as could happen in a market crash), the guarantee repayments could lead to the originator’s bankruptcy. Therefore, the guarantee is preventing minor losses (from borrowers’ failure to pay back the loan) but exposing you to the originator’s complete bankruptcy. I assume an LO’s bankruptcy will lead to a 50% loss of capital for my calculations.
You should therefore diversify across LOs, especially if they offer a Buyback Guarantee.
3. Platform risk
What happens if the platform (e.g., Mintos, PeerBerry, or EvoEstate) you invest through goes bankrupt? As there isn’t any contact directly with the Loan Originator or the lender, such a situation wouldn’t be easy to navigate. Especially, if some LOs go bankrupt at the same time.
Investigate the financial health of the platform you plan on using. Most aren’t profitable but is it due to their focus on growth, or is their model inherently flawed?
I wish more platforms would publish business continuity plans. It gives me confidence in a business’s operations to know is aware that for whatever reason, it might not exist forever. If you are curious what such a plan looks like, here’s Vanguard’s.
Finally, platforms can themselves be Loan Originators (e.g., Twino). This doesn’t mean you are taking on more risk as long as you diversify and not put all your eggs in the same basket/platform.
4. Expect losses in case of a downturn
As shown by the market drop in 2020, LOs will go bankrupt if the market drops significantly. This is primarily due to the guarantees they provide: As lenders fail to repay their loans, they suddenly need to cover large amounts of guarantees and fail to do so.
If you were looking to protect your capital in case of a market crash, maybe look into bonds.
5. Taxation could be a reason to go into P2P Lending or to stay away
Taxation is, of course, very country-specific. As always, it can make or break an investment. After searching this topic, you should at least be able to answer:
- How are interests taxed?
- Can losses be offset against gains?
Note that understanding the tax consequences of losses is essential: If allowed, this means you can highly increase the net return of your investments (I might write more on that topic in the future. For now, make sure also to investigate the question of when you can claim the loss. It sometimes takes years for a lender to be confident a repayment won’t happen. If it’s only at that point that you can claim the loss, there’s a huge opportunity cost).
6. You might need to actively manage your investments
Most platforms offer some “Auto-Invest” feature, so you do not have to invest 50€ at a time which wouldn’t be practical. But even then, you might have to regularly review your configuration, which might not be worth it if you’re only investing small amounts.
A downside of investing automatically is that you can’t look critically at the loans. You might end up investing in loans that you would have stayed away from if you were investing manually.
7. Lack of liquidity and opportunity cost
Loans can have terms from a couple of months to a couple of years. You have to trust that all the intermediaries will continue to be there for the foreseeable future.
Some platforms offer a system to get your money back quickly, even if it’s invested in long-term loans. However, this shouldn’t be relied upon to stop your investments in case of market crash as everyone will be trying to do the same! I worry those platforms are giving their customers the wrong expectations.
8. Currency risk
Most European P2P Lending platforms offer loans exclusively in Euros. You might decide to invest in other currencies, but you are taking on additional risk that might not make sense if you live in the EU.
9. Some investments are morally hazardous
Debt is only a tool. Although sometimes helpful and necessary, debt can also hurt the borrowers in the case of predatory practices. You should select LOs based on their use-cases and interest rates for borrowers.
Note that predatory lending often ends up being forbidden through legislation. Therefore, it might also make financial sense to focus on LOs that you believe have morally more acceptable practices as they could have higher odds of operating in the long term.
10. Institutional investors are joining the party
For years, institutional investors mostly stayed away from P2P Lending in Europe. Gradually this is changing. Recently, Mogo issued bonds that were quickly oversubscribed, and EstateGuru shared that their number of institutional investors is growing.
More investments into P2P Lending can decrease interest rates as more investors are competing over the same loans. Considering this doesn’t change the loan’s default risk, there might be a point when it doesn’t make sense to continue this type of investment.
High-quality Loan Originators are also likely to prefer working with institutional investors: It’s a lot easier and therefore less costly to deal with a couple of large investors than with 50,000 small ones. They also get to avoid paying intermediaries (the platforms). And I can only imagine regulations are easier to follow as they aren’t dealing with private investors anymore.
Can you think of something else?
Those are the main risks and challenges I can think of! If you think I missed something, let me know. And again, I do not think I believe investing in P2P Lending is a terrible idea. On the contrary. I just like to know what I’m getting myself into. :-)