Peer to peer lending has been becoming increasingly popular in recent years. As the other investments like saving accounts and certificates of deposit provide a low-interest rate, more and more people are attracted to P2P lending. Peer to peer lending is a way to lend and borrow money without any traditional financial institution. This type of investment offers high-interest rates; however, it carries a level of risk like all investments. The risk is higher when you invest through illegitimate or unsecured platforms. If you are thinking of investing in P2P lending, you must keep in mind the risks associated with it. Here are the significant risks that can result in the loss of money.
Credit risk is the risk when a borrower would not repay the loan. It is also known as borrower default or bad debt. It is the most common risk associated with peer to peer investment. When a loan goes bad, you may lose your money. However, some platforms offer contingency funds to cover the loss. But if multiple loans go bad simultaneously, this fund does not protect you. Borrowers may default due to several reasons such as sudden loss of job, property valuation, or when the platform does not carry out credit score evaluation correctly.
This risk is associated with changes in economic factors that affect the borrower’s ability to repay the loan. Market risks are specific to the loan type offered by P2P platforms. Some main factors that cause market risk are as follows:
Borrowers find P2P lending more attractive because the interest rate offered is less than the traditional loans. When the interest rate becomes high, fewer borrowers are attracted, and investors can not find borrowers to lend money.
When unemployment increases, the chances of default borrowers also increase.
When you invest in property loans, the loan to value (LTV) changes with the price of the property. LTV increases with the decrease in property value. When the property’s value decreases, it becomes difficult for the borrower to repay the loan amount and interest.
Like other companies, there is a chance that the peer to peer platform may go bankrupt. It can be due to poor management, lack of investors, and a high number of default borrowers. Another risk associated with the platform is that the Financial Services Compensation Scheme does not protect P2P platforms. No doubt all the platforms are authorized by the Financial Conduct Authority, but it only regulates platforms to follow best lending practices and does not protect your investment directly.
Diversification is a key to reducing risk. When you invest all your money in one type of loan, there are more chances of losing money. In this case, if a borrower defaults, all your money is gone with it. However, when you spread your investment across different types of loans, you can still get a return if a borrower defaults. Therefore it is vital to diversify your portfolio and mitigate risks.
Now that you know all the risks associated with peer to peer lending, you must take into account and invest in a way to reduce these risks.