Peer-to-peer (P2P) lending is an opportunity, where individuals do not have to use an official financial institution as an intermediary. To put it simply, it removes the middleman from the process. So if you need a loan, and you have good credit, you ask from P2P lenders, they evaluate the risk, and might give it to you with a low loan rate.
The history of P2P lending takes us to the sixteenth century, where first there was just a social lending. It means, people who had money to give, gave it to those, who needed money. Lending as a way to earn money, became popular 21st century with the development of technology and economic growth.
What are the biggest P2P lending platforms?
In Latvia and Baltics, the biggest platforms are Mintos and Twino. Mintos started in early 2015, and in 4 years they already have more than 58,800 registered investors from more than 68 countries, helping to fund 678 million euros worth of loans. Twino, what started operating in 2009, is even said to be the third largest peer-to-peer consumer lending platform in continental Europe. The company operates in nine countries across the world and has issued more than 332 million euros worth of loans.
World’s biggest P2P platform is Lending Club Corporation, which was founded in 2007. Since then the company has issued loans in the total amount of $41.6 billion. The most common loans are for personal finance, for example, consolidate debt, to pay off credit cards, for home improvements and pool loans, and also for business loans, patient financing, and investing.
Why is P2P lending appealing to investors?
Peer to peer lending, in general, seems like a good option for those who want to get higher than average annual returns. For instance, both Mintos and Twino offer approximately 11% annual interest rate. Globally, the rates are between 10 and 15 percent. However, with great opportunities comes great risk. In order to properly judge this form of investment, we must first evaluate its positive and negative sides. The most interesting aspect to look at is peer to peer lending model’s performance during an economic recession.
What will happen to peer to peer lending during a crisis?
In order to get the needed loan from a bank, the average person should go through a very long and time-consuming process, which can take up to months. Banks are very strictly regulated institutions, and if a person has any issues with credit history, the banks will more likely pass the opportunity to lend him the money. P2P lending, on the other hand, reduces the complexity of getting a loan. Besides, people who can’t get the loan from the bank can possibly get it from a P2P lending platform. These people, however, are charged with a higher interest rate, which is not a surprise. Nevertheless, applicants can receive funding in a matter of days.
Often people move to P2P lending only because the bank could not provide them with the desired loan. It can be an indicator that people have previous issues with debt repayment, which also means they are not good with handling finances. Indeed, the “bad loan” ratio in a P2P lending model is considerably higher compared to traditional banks. If we combine high interest rates with a bad ability to manage the debt, we get a customer who could easily miss the payment deadline or not repay the debt at all.
Now imagine the situation of crisis. Monthly wages decrease. Unemployment spikes. The crisis affects nearly everyone. How many people are not paying their obligations in these circumstances? The amount can easily exceed 20, 30, or even 40 percent. For investors, it will be a true disaster. So, during the crisis, the risk of losing the invested money is quite decent. Although investments could be insured and/or secured by the lending platform, the situation is not as easy as it seems.
Firstly, the government does not provide any kind of insurance for lenders, so the second (and last) option is to rely on loan insurance by lending platforms. However, things get tricky here. Each lending platform has its own rules and legislation. For instance, we can compare two biggest lending platforms in Latvia – Mintos and Twino. In the example with Mintos, the platform plays only a role of a middle-man, in other words, the loan insurance (if it exists) is provided by loan originators. In contrast, Twino itself distributes loans, so your loan is protected only by Twino (of course, if the insurance is mentioned in initial agreement). The main problem arises when a large number of people cannot pay off their debts (such as during situation). The capital of lending firms is considerably smaller than the total amount of loans they have issued. When the crisis occurs, the firms can’t possibly repay all “insured” loans simply because of the lack of capital and goes bankrupt. This, of course, is the extreme, but likely to happen scenario.
But is it all truly that bad?
Again, the average interest rates in this kind of investment are 10-15%, which is a significant number. Moreover, we as lenders can choose in which lean to invest and also diversify among different loans. For instance, a lender with the capital of 500€ can diversify among 10 loans by contributing 50€ to each loan. Also, a huge benefit is that everyone can start investing with an average entrance amount as small as 10€.
In addition, lending platforms provide loans with different amount of risk involved. In the graph below there are reflected average yearly interest rates for different types of loan. “Grade A” meaning that the loan is very secure and is likely to be insured by loan originator and “Grade G” meaning that the loan is very risky and without any insurance. The statistics are provided by the company “Lending Club”, the world’s largest peer to peer lending platform. The average interest rate fluctuates between 10 and 15 percent.
Another positive side is that P2P lending might become even more popular in the future as it offers a smaller interest rate for borrowers compared with banks. The following graph shows that the interest rate difference between bank loans and secured P2P loans on average is around 4%, which can be game-changing for those people who take big loans such as mortgage, or even for people who want to save up on their debt repayment.
Overall, the main advantage of P2P lending is its high interest rate and ability to diversify among different risk level loans; besides, a lender can choose on his own in which loans to invest. Although some of them are even protected, it means the average return will be less compared with more risky loans, investing in which sometimes is more like a gamble rather than an investment.
So, is it worth investing?
Peer to peer lending has definitely proved itself as an alternative to loans issued by banks, and have revolutionized consumer lending industry. In this model, both lenders and customers get benefits. Lenders receive slightly higher average returns compared to bonds/stocks (for example, S&P500 average annual return is about 10%). Borrowers also benefit as their loan may receive less interest rate than the one provided by banks.
Every investment has its pros and cons; in P2P lending case, the model could be very fragile during the crisis situation. On the other hand, the crisis will affect nearly every type of investment, and P2P lending is not an exception. In general, P2P lending is not a get-rich-quickly scheme. Rather, it provides the investor with a better interest rate, which comes with the potential risk of great losses.
Pros of P2P lending:
high interest rates for investor (10-15%);
opportunity of diversification among different loans and risk levels;
investor can pick on his own in which loans to invest;
some loans are fully or partly secured by loan originators;
investing doesn’t require much time and knowledge: almost all information is available on the lending platform.
Cons of P2P lending:
lenders don’t receive government protection;
investors also issue loans to people who are not so good with their finances;
borrowers may not repay their obligations;
the risk of losing money is still present;
liquidity of this investment is low (once investor lends the money, he will get it back only after a certain period of time).
Authors: Romans Madesovs, Martin Hobemagi
The information in this in this article is for general information only and should not be taken as an investing advice.