Peer To Peer Lending: Income Investors Should Consider P2P

The financial media typically covers short-term opportunities which applies mostly to stocks, but you’ll also hear about bonds that are “up” or “down” due to price fluctuation. Even with the Bank of England keeping interest rates so low for so long, still they fear that market prices for bonds might crash any interest rates rise.

Newly issued bonds will pay higher rates, so bond prices must decline as rates go up. This can be painful for investors holding shares in bond funds since there’s no guarantee that you’ll make up those losses by the time the rates fall again. Therefore, it is better for long-term investors to hold and control their own investments.

But apart from that, there is another interesting option that these income-seeking investors should consider – peer-to-peer lending.

Peer-to-peer (P2P) lending is an alternative source of income that could work out well for investors who take the time needed to understand the risks and rewards.

How Peer-To-Peer Lending Works

Peer-to-peer lending lets you make loans to individuals or participate in pools of loans, if you want to limit your risk.

Those borrowing money are credit-checked and receive a risk rating that tells at what rate they can borrow. So you can always check the borrowers’ credit scores (as part of Stratopshere’s workflow for investors) which will help you decide how much credit risk to take.

Those looking to lend are able to generally get better rates of return rather than keeping funds in a low savings deposit account via a bank.

Peer-to-peer lending, also known as crowd-lending, is made possible by P2P lending websites or platforms. These websites are industrial-scale online financial matchmakers that facilitate the money lending process by matching individual borrowers or companies with savers willing to put money aside for long period of time, aiming for a good return.

Take a look at our ‘Stratopshere Peer to Peer Lending – How it works‘ video for an overview.

Risk Versus Reward

What are the risks of peer-to-peer lending?  

Not all platforms will allow you to pick your borrowers. There are those where the borrowers are picked for you.

P2P lending platforms that let you choose your borrowers will allow you to assess the credit risk of a given business or individual before pressing the button on a loan or enagaging by other means with your facilitator or broker. Therefore, if you have chosen only four borrowers, by default, you could lock in or risk up to 25 per cent of your capital.

While with those platforms where borrowers are chosen for you, your money will be divided up before it will be lent. Therefore, if your loan is spread over 20 borrowers, each individual default has a much lower impact.

If a borrower does fail to repay what they owe, the platform will have certain contingencies − often takes the form of a reserve fund from which it will pay you your dues, and to which the borrower will then pay their arrears (or eventually face a call from a collections agency). Some peer to peer platforms do not provide any security for investors and this should be carefully investigated before investing - this of course will increase the risk!

Another possible risk is when the lending platform itself collapses. Though P2P platforms are now regulated by the Financial Conduct Authority (FCA), their lenders are not protected by the Financial Services Compensation Scheme – the body that will give savers their money back if their banks go bust.

On the other hand, firms that are covered by the FSCS are required to pay a large amount that goes into a compensation fund. If P2P platforms were saddled with such a fee they might be forced to take higher margins, and to lower their rates as a result.

So if the platform went bust, the individual borrowers will still have to repay their loans at the same agreed rate, and in theory you should still receive the money you were expecting. This is further backed and more secured where P2P platforms, such as Stratosphere peer to peer lending take a first-charge security over the loan on behalf of their investors.

However, if your loans have been spread over dozens of borrowers, arranging and enforcing repayment of all these could be a nightmare. Some platforms have arrangements with third parties to arbitrate in these circumstances.

What can you get?

One positive characteristic of peer-to-peer lending is that it’s inexpensive and usually has very low minimum investment requirements. It does involve you locking your money away, though some platforms offer accessibility if necessary. The longer you are willing to tie up your money, the more you will earn.

Low Credit Risk

“P2P has been successful because it’s right in the middle. There is an element of liquidity risk and there’s some credit risk, but I would say it’s a relatively low amount of credit risk. It’s far, far less than the amount you would lose in a bad year on the stock market.”

As competition heats up, the pressure will be on platforms to accept borrowers who don’t quite meet the most demanding standards of credit risk. But nothing’s wrong with taking more risk as long as platforms make the risk clear and pay higher rates to compensate.

The other thing to be mindful of is the interest rate environment. The peer-to-peer sector has prospered during a lengthy period of low bank base rates. But what happens when bank interest rates go up? Will peer-to-peer platforms be forced to squeeze margins or take on riskier borrowers?

“Peer-to-peer platforms may be able to keep their rate differential at a wide enough level to attract new investors and borrowers.” according to Andy Caton, executive director at Yorkshire Building Society.

“However, when the base rate rises, it is important to remember that there is usually a corresponding upward move in the cost of borrowing, which can result in an increase in defaults across all types of loan. This uncertainty reflects an added risk to investing in P2P compared to standard retail savings.”

The development of P2P lending has led to a new investment opportunity for income-seeking investors who are willing to take control of their actions through a higher level of risk management.

The increased participation from these investors gives a strong indication that peer-to-peer lending is here to stay.

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