Peer to peer investing is risky business, but there are steps you can take to minimize your risk.
At its core, it’s similar to lending money to your friend. He might decide not to pay you back, and you might just lose the money or spend a lot of time to recover it in court.
Except that, with peer to peer lending, you’re not lending a big sum to your friend, you’re lending small amounts to hundreds of people and businesses. Even with a 10% default rate, you’ll still have 90% of your investments returning the money and covering for the defaults.
I don’t even count that most likely you wouldn’t lend money to your friend with an interest rate.
Besides spreading your risk into multiple investments, you have contracts that protect your investments and p2p lending platforms take actions to protect you:
- make credit risk assessments
- secure the loans either with physical assets or buyback guarantees or provision funds
- handle the recovery procedures in case of defaults
That translates into less hassle and more profits for you.
What are the biggest risks
You risk losing money
I’m not joking. Put your hard-earned money in a platform, invest in loans to strangers or companies you know nothing about and hope for the best. That’s what you do in a nutshell.
Borrowers may default because they lost their job or couldn’t pay the credit in the first place. Companies default due to a poor economy or bad management. Even the p2p lending platform can become bankrupt.
Your money sits idle
You add all your funds to a platform and then nothing happens, because there are no new loans available. You could have done something better with those funds.
Hackers. They break into your account and steal your funds. Either because you put the same password everywhere, either because the platform has poor security, and anyone can take a peek.
The economy goes bad (it happened!) and there’s a huge rise in default rates. Some platforms have buyer protection in the form of buyback guarantees, but if a certain threshold is reached, they might not have sufficient funds to cover for all defaults.
Some loans are secured by a mortgage or other physical assets, but those are hard to sell for a good price during a recession.
Your money is locked
You need your money in a few days, but you invested in 5-year loans? Tough luck if the platform doesn’t have a secondary market or a way for you to sell your investment back.
How do you minimize your risks
Don’t invest in a single platform
Yes, that one platform is the best. It has the best interest rates and you’re in for the money. Even more, the platform seems solid and has good reviews. Why put your funds somewhere else?
Companies are really good at letting you know when they’re doing great, but they’re less talkative when things go south. What happens if it goes bankrupt and your funds are locked in there for a long time, or even worse, you lose them?
Besides, there are tradeoffs to each platform. One might have lower returns but let you invest in different kind of assets or offer shorter loan terms.
I’m currently invested in 15 p2p lending platforms. Although only 5 of them have serious investments and on a few others, I don’t plan to invest more. That’s either because I don’t like them or because they don’t offer anything different.
Don’t invest in a single country
This doesn’t cover just p2p investments.
It’s pretty common that people invest more in their home country. Your job, savings accounts, bonds, stocks, other investments, they’re all in your country. If your economy goes bad, all your assets will take a hit.
So, spread your investments in as many countries as possible. Some economies will perform worse, but you’ll also be invested in others that are doing better.
I don’t like how my portfolio is spread at the moment. 25% of my p2p investments are in Poland. Also, all of them are in Europe, but that’s a different level of diversification I’m not ready to take on yet.
Don’t invest in a single loan type
Real estate might perform badly but other industry sectors might thrive. Or the other way around. Either way, don’t invest in a single loan type. The more the merrier.
Most of my portfolio is invested in consumer and short-term loans, which doesn’t feel too great.
I also think consumer loans and personal loans mean the same thing, so I can say my portfolio really needs work on this aspect.
Spread your investments over different loan terms
Loans with longer terms might have better interest rates. During a recession, these would be the hardest to get rid of and recover your funds.
Most of my portfolio is invested in loans with periods up to a year.
Don’t invest all your funds into one big loan
Defaults happen. On most platforms, their rate is low, between 1% and 5%, but they do happen. Even though you have a buyback guarantee or the loan is secured, it takes time to recover your funds. And you could have used that time to invest your funds into something better.
My p2p investments are divided into 602 separate loans. 575 of them are less than 50 EUR investments. For some reason, I also have 22 investments in less than 10 EUR loans (I only knew about the 10 loans of 1 EUR I’ve invested in Bondora).
Other measures that help reduce risks
Make sure that the loans are secured by either a buyback guarantee, provision fund or some physical assets.
On secured loans, make sure the loan to value ratio is low enough that will cover your investment even during a recession. There’s also a difference between a first charge and second charge securities (a second charge means you’ll recover your investment only after first charge lenders recovered theirs).
On buyback guarantees, check the rate of late and defaulted loans on the platform. A buyback is great, but you don’t gain much if most of the loans are late with their payments.
On platforms that offer loans from multiple loan originators, spread your investments over more than one. Also, check their ratings (on Mintos) or manually check how many of their loans are late or defaulted. You might want to avoid them.
I’m sure this is not a complete list of ways to reduce your risks in p2p investments.
I’m relatively new to peer to peer investing, so there is constantly new stuff I learn. Some parts I learn from reading and others from my own experience.
Writing these articles helps me deepen my p2p investing knowledge. And to some lesser degree, it might also help you learn something new.