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 sheer number of company and loan choices would be overwhelming.
I believe that peer to peer lending offers something for everyone and has a place in a diversified investment portfolio. Younger investors like the higher risk / higher return investments and enjoy the variety while many retirees I speak to are investing through Ratesetter, Funding Circle and Assetz Capital as a way of providing monthly income. Peer to peer lending in many ways, can act similarly to a fixed income bond product that can be extremely useful for those nearing or in retirement age.
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 p2p portfolio, this page is a great starting point.
I’ve spent several 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.
Be Careful Chasing High Lender Interest Rate Returns
As a lender, it is very easy to focus purely on the return rates that peer to peer companies offer. This is an investor character flaw which plagues most of us, even casual stock pickers chasing performance rather than studying company fundamentals.
Here’s the problem. Interest rates often don’t correlate to risk levels. A 12% paying loan could be less risky than a 6% loan. Most of the time, peer to peer investors have no idea the spread differences between lender and borrowers because most companis does publish such loan book details.
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 borrowers interest rates based on perceived risk. So when a peer-to-peer company is offering you the lender double-digit return rates, it’s usually because the security and the borrower are considered high risk. If you are receiving 12% p.a. returns, the borrower could be paying 20%+ per year. This is so often overlooked in peer to peer lending as lender’s place so much trust into the hands of the peer to peer companies underwriting process.
Making investment decisions based upon returns can be 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 the offered lender return rates were so high.
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 searching forever.
Some companies offer great loan products but don’t offer enough new loans for new lenders to become properly diversified. Other companies offer lots of new loans but the interest rates are too low to justify the risk. Some companies have more underwriting, credit risk and default recovery 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 when you want out.
Many times you will have to overlook the negatives and dive in. Just remember to assess all the pros and cons 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.
Company History Is Important…Sometimes
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 speaking with the people in charge and research available on the internet. 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 through other ones. There are now additional resources on the web to help you perform due diligence on the companies.
Thankfully only two of the companies I originally invested through ceased trading. I’m learning that while company history is important, it’s not the most important factor when making investment decisions. Sometimes I feel more confident in companies that have less trading history versus the ones that have been established longer.
Lending Products Are Vastly Different
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 whether you are investing in a chicken or a house loan, a loan is a loan and as a lender, you risk your money and hope to receive interest and return of capital.
When considering lending, the things that truly matter are:
- The loan security and the peer to peer companies ability to accurately assess the value
- The borrower’s ability to repay the debt and interest
- The lending companies ability to collect timely loan payments and interest
- The lending companies ability to quickly legally acquire the security upon a default
- The ease in which the security can be sold (it might be easier to sell a cow than a power plant)
- The lending companies competence in cost-effectively disposing of the security upon default
You may be more comfortable lending against one type of loan security 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.
Director and Staff Experience
The experience of the Directors and staff running the peer to peer and crowdlending companies was mostly an afterthought 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 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.
If we compare peer to peer lending to other investments such as bank savings accounts or index tracker funds, 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 used to consider unsecured business lending far riskier than secured property lending, however, I soon discovered that this is isn’t always the case. For example, one property loan I owned that defaulted was misvalued and sold for 50% of its loan value. Another defaulted property was found to have subpar building materials so extensive remediation was required causing delays and extra expense. Another bad property loan I owned, a subcontractor who hadn’t been paid but the defaulted borrower poked holes in all the plumbing pipes which caused water damage behind finished walls.
Risk isn’t always easy to quantify but I consider lending against cars riskier than lending against a piece scrap gold because cars depreciate 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 have enough funding 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 lenders often overlook loan risk because it is difficult to gauge. As I mentioned before, 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 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 poor, my risk tolerance rises as peer to peer looks more attractive. If and when interest rates increase, risk tolerances will change and adjust.
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 the 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 leaves money lenders’ money tied up indefinitely.
Some companies are more effective at 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 no experience in property recovery. 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 and will happen, so it’s important to decipher which companies are competent in recovery.
As one Financial Thing reader who worked in banking told me “Bankers have always understood that part of any loan book will sooner or later be labeled non-performing.”
Even A Perfect Loan Can Go Wrong
I learned this the hard way when I invested a larger than normal sum of money into a high rise property development. I studied the numbers and deemed this particular loan to be one of the better ones offered through a peer to peer lender. When the loan defaulted well into the development stage I soon realised that even the best loans are prone to failure. Contrarily, some of the worst looking loans I have invested in have been repaid with no lapse in payment so loans can defy all logic.
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 a company I invest through fails (hello Collateral), 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 higher 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.
I Expect On Average, To Earn About 7% Per Year Investing In Peer To Peer Products
No longer do I have expectations of 12%+ annual earnings. If I diversify correctly, 7% is my target.
Don’t Put All Your Investment Eggs Into The Peer To Peer Lending 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 any higher 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 Managing Your Peer To Peer Lending?
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, Lendy releases new loans on a regular basis so you may spend time buying and selling loans on their secondary market.
There are several companies including Assetz Capital, Ratesetter, Lending Works, Landbay, Growth Street, Funding Circle, Zopa and Bondmason that offer completely hands-off investment products that require very little 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 well worthwhile.
Don’t Be Loyal / Make Changes As Needed
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 reinvest 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 isn’t rewarded.
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 from 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.
The FCA or Financial Conduct Authority is an independent regulatory body which reports to the UK Treasury department and the Parliament. The FCA’s board is chosen by the Treasury and this board manages the senior executives. In order for a peer to peer or crowdlending company to receive FCA regulatory status, they must go through a long and arduous process.
It’s important to make sure any company you invest through is operating under FCA permissions. You can use the FCA’s search tool to verify.
After the Collateral debacle, it became apparent what an important role the FCA plays in peer to peer lending sector regulation. Collateral assumed they were operating under FCA regulatory permissions but were not. When the FCA discovered the regulatory issue, it forced Collateral into administration.
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 accounting measure, but also reported 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.
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. Just because a company is offering loans doesn’t mean they’re good loans. Sometimes it’s better to sit on the sidelines and wait for a more favourable 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 weeks 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 practised 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 peer to peer lending guide, 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. Thanks for visiting Financial Thing.
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** This page is for information purposes only and should not be considered investment advice. Opinions expressed on this page are based upon my investing experiences. All information was deemed to be correct at the time of writing. Peer to peer lending contains risks so never invest more than you can afford to lose. **