Peer To Peer Lending Guide
As peer to peer lending rapidly grows, more and more companies are launching. If I were a peer to peer lending beginner, the plethora of company and product choices would be overwhelming and possibly off-putting.
I truly believe that peer to peer lending has a place in a diversified investment portfolio as peer to peer lending offers something for everyone. Younger investors like the higher risk investments and enjoy the variety while many retirees I speak to are investing through Ratesetter, Zopa and Assetz Capital as a way of providing monthly income. Peer to peer in many ways, is similar to a fixed income bond product that can be extremely useful for those nearing or in retirement age. Many of the peer to peer companies are experiencing higher demand than supply which offers lender’s a quick exit via their secondary markets.
I know what you’re thinking, “Laurence, where do I begin?”
Whether you’re a complete peer to peer lending beginner plucking up the courage to make your first deposit, or a seasoned investor looking to shake up your portfolio, this article is a great starting point.
I’ve spent the last three years learning about peer to peer lending. It’s been a journey with many bumps along the way. If I were able to travel back in time and tell myself about peer to peer lending…
…here are some of the primary considerations I’d tell myself to ponder before investing.
The Perfect Peer To Peer Company Doesn’t Exist
All companies have pros and cons so if you’re looking for the perfect resting place for your cash, you’ll be waiting forever.
Some companies offer great products but don’t offer enough new loans for new lenders to become fully invested. Other companies offer lots of new loans but the interest rates are too low to justify the risk. Some companies have more underwriting and credit risk experience than others. Some companies have websites with technical problems; others deposit too slowly or don’t have a functioning secondary market to sell loans.
Many times you will have to overlook some negatives and dive in. Just remember to assess all the positives and negatives before you invest and make sure you fully understand the risks involved. You can also save yourself some time and read my peer to peer lending reviews, or drop me an email and I’ll give you my opinion.
When I first started peer to peer lending, some of the companies I invested through had very little trading history. Part of my investing decision was based on company information I was able to gather on the web. I also read through the company websites and decided how comfortable I felt. If my gut said no, I didn’t invest. As time progressed and I became more experienced, I made several adjustments by moving out of certain companies and investing into other ones. There are now additional resources on the web to help you perform due diligence on the companies.
Thankfully all of the companies I originally invested in are still trading. I’m learning that while company history is important, it’s not the most important factor when making investment decisions. In 2017, I feel more confident in some of the companies that have less trading history versus the ones that have been established longer.
Director and Staff Experience
The experience of the Directors and staff running the peer to peer and crowdfunding companies was mostly an after thought for me when I started lending. As I have more lending time under my belt, I realise how essential Director and staff experience really is. If the Directors fail to evaluate credit and borrower risk accurately, those companies will not survive long-term and your capital could be at risk.
My website has enabled communication directly with many of the people in charge of the peer to peer lending companies. This in turn allows me to gauge the experience of the company Directors and the company staff. While there’s no guarantee that these Directors will lead their companies to success in the long term, it’s certainly helpful to have these types of conversations. I encourage you to watch my upcoming podcasts so you can become familiar with the people who you are entrusting your money to. Also do not be afraid to call the companies and ask difficult questions. Remember, it’s your money and…
Since each peer to peer lending company offers different lending products, it’s easy to be swayed towards a loan because it’s security is something unusual like a boat or a plane. At the end of the day a loan is a loan, no matter the type of security. As a lender, you put risk your money and hope to receive interest and return of capital.
The things that truly matter are:
- The secured item is valued correctly
- The borrower’s ability to repay the debt and interest
- The lending companies ability to collect timely loan payments and interest
- The ease in which the security can be sold (it might be easier to sell a cow than a camper van).
- The lending companies competence of cost effectively disposing of the security upon default.
Now you may be more comfortable lending against one type of loan versus others. I have a friend who is a property surveyor so he’s able to easily identify whether or not a property valuation is accurate. My friend knows nothing about jewellery or cars, so his natural lending choice is property loans. I have another friend who’s extremely knowledgeable about cars so he chooses only to invest in auto loans.
If you have a certain expertise in a particular lending sector then it would be wise to invest in this sector because you can evaluate the accuracy of the valuations.
Always remember that whether you loan money against a shipping container full of Monster Munch or a Ferrari…
…your number one concern is the return of your capital and interest.
Lender Interest Return Rates
As a lender, it is very easy to focus purely on the return rates that peer to peer companies offer. This is very much a behavioral issue, one that seems to plague casual stock pickers chasing performance rather than studying fundamentals.
Making investment decisions based upon returns is all well and good while times are rosy, but when the economy sours and loan defaults rise, you might be wishing you’d paid more attention to why offered lender return rates were so high. It is very important to understand higher return rates often accompany higher risk.
Think about this from a logical perspective. If you were looking to borrow money, you’d shop around for the lowest interest rate. Lending companies offer their borrower interest rate based off perceived risk. So when a peer-to-peer company is offering you double digit return rates, it’s usually because the security and the borrower are higher risk.
If we compare peer to peer lending to other investments such as bank saving accounts or shares, there is obvious risk involved. When you buy a tracker fund, you might lose 10%, 20% or even 40% in a market downturn, but you can be pretty certain the fund price won’t go to absolute zero. With peer to peer lending, although unlikely, there is always a chance you could lose all your capital. Therein lies the risk.
Peer to peer lending contains other layers of risk. I consider unsecured business lending far risker than secured property lending. I also consider lending against cars riskier than lending against a piece scrap gold because cars lose value daily.
Some peer to peer companies are riskier to invest through than others. A smaller company may be operating at a loss and might not be funded to continue operating in this manner. A larger growing company may be backed by venture capital and have the resources to operate at a loss for many years.
Loan risk is sometimes difficult to gauge so lenders often overlook it. A 12% return loan may be less risky than a loan paying 6%. Because many lenders don’t have the time or experience to evaluate the loan risk, they often assume the 12% loan is riskier.
Risk also changes as interest rates change. When it was possible to buy a one year bank bond yielding 5%, I wouldn’t have invested in peer to peer lending at 6%. The extra 1% for the added risk doesn’t make any sense. Now interest rates are rock bottom, my risk tolerance rises as peer to peer looks more attractive. If and when interest rates increase, risk tolerances will change and investments will need adjusting.
Readers often ask me why I don’t pay more attention to company accounts. It is possible to view some peer to peer company accounts but these can be difficult to analyse. Accountants are creative and can use business tax laws to manipulate profit, losses and debt structure. I’m not an accountant but I do know numbers can be manipulated far beyond my comprehension. Just think of the countless news stories about multi billion pound companies falsifying their books in order to manipulate share prices.
For example, in 2014, internet goliath Twitter reported a loss of $0.96 per share using one measure, but a profit of $0.34 per share using another.
Company accounts don’t always accurately portray company financial health and it’s very difficult knowing what goes on behind closed doors. Obviously it’s better if a company is operating profitably but this isn’t always transparent. You can search for company accounts using Companies House website.
Finally when considering risk, this changes depending on how much of your net worth you are investing. If you are investing 1% of your liquid net worth, your risk tolerance could afford to be much higher than if you were investing 50% of your net worth. If I were investing a tiny percentage of my net worth, I’d probably opt for the higher risk 12%+ interest return sites because the risk of loss wouldn’t hurt my overall financial portfolio.
When I loan money, I now pay closer attention to loan security and the company’s ability to recover the security in order repay lender’s capital and interest.
For example, scrap gold has a shorter legal recovery time and is easier to sell providing the price of gold is stable and items were valued correctly. Compare this to a piece of property that must weave through the legal system to be foreclosed upon. This can take several months, if not years. Once the legal red tape has been cut through, the property must then be marketed and a buyer sought. This lengthy process can be costly and result in a lender’s investment capital being placed in a holding pattern.
Some companies are more effective recovering defaulted loans than others and if you dig deeper, you will find some companies are better at recovering certain types of loans. One company may offer both gold and property loans but have little experience in recovery a property loan. After all, what good is a secured loan if the defaulted security can’t be recovered?
While seeing the dreaded “loan defaulted” tag next to a loan you own is poo, defaults are a natural part of the risk that occurs within peer to peer lending, so it’s important to decipher which companies are competent in recovery.
Diversify, Diversify, Diversify
Even if I were not writing content for this website, my peer to peer lending portfolio would be very spread out and diverse. I invest money across various types of lending products that pay varying interest returns. I do this in order to reduce risk. If one company were to fail, my total portfolio would not be drastically hurt. For those seeking maximum returns, you are probably looking to sink all your cash into the highest paying return websites. This is a fine option if you don’t mind the risk.
The same goes for loan diversification within a single company. I choose not to put too much money into any one single loan because if that loan defaults, loss of capital will really hurt overall returns.
Also think about sector diversification. If you invest all of your money into property and the property market downturns, your returns will suffer. I diversify by investing across various sectors such as property, cars, businesses, jewellery and consumer loans.
Don’t Put All Your Investment Eggs Into The Peer To Peer Basket
This goes along with the diversification point. Sometimes I hear of lenders who invest frightening percentages of their net worth into peer to peer lending simply because the returns seem easier to achieve than other forms of investing. I think this is crazy. I can’t explain how sick I felt when I lost six figures during the 2008-2010 property crash. This experience taught me how important diversification is.
No matter how rosy the outlook, one change in the economic environment can bring an investment sector to its knees. Always remember this when deciding how much of your hard earned savings to invest in peer to peer lending.
I currently have about 13% of my liquid net worth in peer to peer lending. I doubt this will increase more than 15%. This is what I’m prepared to risk. Yes losing 15% of net worth would be sickening but it won’t bankrupt me.
When people ask me how much of their nest egg they should invest in peer to peer lending, I answer, “How much can you afford to lose and continue to sleep at night?”
This is a very personal decision that varies from person to person. Age plays a factor in regards to how much time you have to recover from a loss. Is it likely you would lose all of your money in peer to peer lending? No, but it’s possible.
My ideal investment portfolio would look something like this:
How Much Time Do You Want To Spend?
Peer to peer lending can be extremely time-consuming so ask yourself how much time you want to be spending managing your investments. Different companies require different time commitments depending on the loan lengths and the new loan activity. For example, Saving Stream releases new loans on a regular basis so I spend some time selling older loans and buying new ones.
There are several companies including Ratesetter, Lending Works, Landbay, Assetz Capital, Zopa and Bondmason that offer completely hands-off investment products that require very little lender management. Some of these companies pay lower returns for the convenience so there is a trade-off, but for some people this trade-off is worth it.
Loyalty And Changes
I know email inboxes can become overwhelmingly full, but it’s important to read the peer to peer companies emails to see if they have made any changes, particularly to the way they operate or to the products they offer. Sometimes peer to peer companies make instant baffling changes that negatively affect the lending products they offer. I have no problem exiting a company if I’m unhappy with their product changes or reduced interest rates. I can always buy back in later.
Don’t feel the need to remain loyal to any particular company if you feel concerned. Just as you would with your savings accounts, it’s okay to search for better peer to peer company alternatives if you’re not happy.
It is fine to make adjustments and move money between platforms. Loyalty won’t get your capital back if a peer to peer platform goes out of business due to poor management.
Tax Considerations / ISA
When factoring in tax costs, peer to peer lending can return less than expected. Using an ISA to invest in peer to peer makes tax sense for most people, but individual tax positions vary and should affect your peer to peer lending decisions. The strange IFISA rule doesn’t allow lenders to invest their current year ISA allocation into more than one peer to peer company. Lenders can reinvest previous years ISA into multiple peer to peer companies although many companies have a £5,000 minimum ISA investment amount. For many people, using the current years ISA allocation can prevent them truly diversifying their peer to peer lending.
Thankfully ISA rules do allow a split into Cash, Stocks and Shares and the IFISA such as peer to peer lending so that allows some diversification.
If you’re confused about whether or not a peer to peer lending ISA is right for you, consult your tax professional.
I no longer make rash decisions when it comes to peer to peer lending. When I pick a company to invest through, I wait 24 hours before making a deposit to really consider my choice.
I practice patience when picking out investments within a company. Just because a company is offering loans doesn’t mean they are good loans. Sometimes it is better to sit on the fence and wait for a more favorable opportunity, even if this means your money isn’t collecting interest. Early in my investing days, I made some hasty decisions I regretted. For example, I would buy a loan on impulse, do some further research and find the loan was a bad investment and end up selling it a few months later. If I’d had waited before investing, I wouldn’t have purchased the loan.
It has taken me several months to become fully diversified through certain companies but I am glad I practiced patience.
For me, peer to peer lending is fun and engaging. When you invest in the stock market, shares are intangible. When you purchase a peer to peer loan, there is often a tangible item that you loan money against. While you can’t actually touch the item, it’s fun looking at the photo of a Bentley you loaned £25 against.
Sometimes property loans might be offered near where you live so you can view the development progression. In my hometown Poole, I regularly drive by the sites I have loaned money against.
In this guide to peer to peer lending I have highlighted some of the main considerations I pay attention to when making investment decisions. If you are looking to get your peer to peer lending feet wet, read my current Top 5 Peer to Peer Lending Sites guide and also read the many unbiased peer to peer lending site reviews on Financial Thing.