P2P Defaults Explained
The rise of peer-to-peer (P2P) investing has been fuelled by a combination of low savings rates and stock market volatility, which have forced interest-seeking investors to search elsewhere for decent returns. The arrival of the Innovative Finance ISA (IFISA) has only made P2P investing even more attractive, as investors can chase returns of up to 15 per cent per year, tax free.
But as with any investment, there is always a catch. P2P investing comes with low fees and above-inflation returns, but it also comes with a certain degree of risk. Specifically, the risk of defaults.
What is a default?
A default is a missed payment on a loan, which can result in the loan going unpaid. Any P2P investment is an investment in a loan – whether that may be a consumer loan, a property loan or a business loan. This means that any P2P investor is banking on these loans being repaid according to a pre-agreed timetable.
However, defaults do happen. According to the Peer2Peer Finance Association, the average default rate across the P2P sector is around two per cent. This figure is usually taken into consideration when platforms advertise their target returns – for instance, if target returns are 15 per cent, the platform may tell investors to expect 12 per cent, to avoid disappointment.
Platforms have also spoken publicly about their desire to help small businesses and other borrowers. Most P2P lenders will have a plan in place to help businesses at risk of default – they may offer free advice, or give them a short-term break from their repayments while they deal with cashflow issues.
In reality, a default will only truly become a problem for investors if the borrower repeatedly underpays their loan, or if the business goes into liquidation.
How to minimise the risk of default
To minimise the risk of losses due to defaulted loans, there are a few things that investors can do.
Invest in loan pools, rather than individual loans
Most P2P platforms will give investors the option to choose ‘manual lending’ or ‘auto-investing. Manual lending is where each loan is hand-picked by the investor. This can potentially reap huge rewards, but it also means that all of the investor’s money could be trapped in one place, so if the loan goes bad, they could lose everything.
By contrast, auto-investing usually involves a multitude of different loans. This means that if one or two loans go into default, the impact on the investor’s overall portfolio will be minimal, and any default-related losses should be offset by the high returns gained on the other loans.
Use a trusted platform
Each P2P platform has its own credit checking process, whereby prospective borrowers are vetted and interviewed before they are approved for a loan. Transparency is hugely important in the alternative finance space, so you should be able to easily find the details of your platform’s credit checking policy on their website, as well as examples of their previous experience with defaults. If you are not comfortable with a platform’s credit process, find another IFISA provider.
Do your own due diligence
Even if you trust your platform fully, it is still important to conduct your own due diligence into each loan, the borrower behind it, and the platform itself. Search Companies House for evidence of previous businesses held by the borrower. You may also be able to view the business’s most recent financials, which will give you a fuller picture of the firm’s health.
Choose asset-backed/secured loans
A secured loan is generally backed by a hard asset of some sort – a property, a business, or even a classic car. This can help reduce the risk of a default as the platform can call in its collateral if a loan is not being repaid, and the value of this collateral should allow the platform to repay (at least) the capital cost to investors.
Never invest more than you can afford to lose
P2P lending has only been around for 15 years, and the IFISA is only two years old. While there have been no major losses to date, it is still a very new type of investment and lenders should be mindful of this before getting too carried away in the hunt for high returns. Never invest more money than you can afford to lose, and you can avoid real financial pain should one or all of your loans go bust.
Updated: Tuesday, June 4th, 2019