Investing your money in financial assets always come at a risk. P2P lending is no exception.
There’s generally six P2P lending risks ranging from somewhat serious to very serious risks:
- Money drag: Your money is not fully invested
- Borrower default: The borrower defaults on the loan
- Loan originator bankruptcy: The loan originator goes bankrupt
- Platform bankruptcy: The P2P lending platform goes bankrupt
- Geo-political and -economic problems: The world turns ugly
- Ethical concerns: The loan purpose is not always clear
Since I have been writing quite a bit about P2P lending including a list of the best European P2P lending platforms, I thought it would make sense to dive deeper into the risks associated with these types of investments too.
Let’s go through each of the five P2P lending risks – and equally important, what you can do to mitigate the them.
1. Money drag
What is it money drag?
Money drag is the least serious risk associated with crowdlending. When you invest in P2P loans they usually have terms ranging from days to months and sometimes to years too.
Once a loan has been paid off by the borrower, you will most likely have to re-invest the loan amount and the interest you have received into a new loan. Most people use the autoinvest function that many P2P lending platforms provide for this.
If the lending platform doesn’t have enough loans matching your loan criteria (e.g. interest rate, loan term), then you will risk having money on the account that doesn’t generate a return. While it is not a disaster, it is definitely not desirable to have money invested at 0% return.
How do you mitigate the risk of money drag?
Money drag is not a common problem on the platforms I am using, but I have seen investors complain about money drag on various platforms from time to time.
So what can you do about it?
First, you should always monitor your investments at least once a month. This way you will be able to identify money drag early on before losing out on too much return.
Once you have identified money drag, you can either change your loan criteria (e.g. lower interest rates slightly) to see whether it can solve your money drag.
If you still experience money drag, I suggest you withdraw the money and transfer it to another P2P lending platforms. I suggest you sign up on other platforms to view the available loans before you transfer money to them.
2. Borrower default
What is a borrower default?
When you decide to invest in P2P lending, you are essentially giving a loan to another person or business.
Just as lending money to a friend, there’s a risk the borrower might not be able to pay back the loan. This is called defaulting.
If this happens, you might already have received nothing or part of the loan back with no or some interest.
Some platforms try to recover your money through various legal procedures, but you do risk losing the money. However, there’s a few things you can do too:
How do you mitigate the risk of borrower defaults?
There’s a few things you can do to minimize the effect of borrower defaults.
Many P2P lending platforms provide a buyback guarantee (sometimes called a default guarantee). This means that the platform promises to buy back the loan from you if the borrower is late with his/her payments (often more than 30-60 days late) – and most of them also promises to make up for the potential lost interest rate.
I almost exclusively invest in crowdlending platforms that offer buyback guarantees. Some platforms offer loans both with and without buyback guarantee, so make sure to choose the loans with a buyback guarantee to be sure.
If you invest in loans without buyback guarantee, make sure to do your research prior to investing (e.g. average default rates of the loans you invest in), so you can factor the risks in when assessing the returns. Loans with a very high interest rate often have the highest default rate.
Finally, you should always spread your risks across many different loans to make sure a single borrower default cannot wipe out all of your invested funds at once. I usually invest no more than a two-digit EUR amount in a single loan (e.g. 10 EUR).
3. Loan originator bankruptcy
What is a loan originator bankruptcy?
Some P2P lending platforms offer loans from different loan originators (e.g. other companies facilitating the loan process with the borrowers) while some platforms only offer loans they have vetted themselves.
If you use a platform that doesn’t use third-party loan originators, loan originator bankruptcy is equal to the next risk: platform bankruptcy.
However, if there’s multiple loan originators on a site, there’s a risk one of them might default. If they default, you can lose your investment too.
If they default, the P2P lending platform’s or your lawyers typically take over and try to recover the investment through normal bankruptcy procedures.
This is quite rare, but it has happened to me once on Mintos with a loan originator called Eurocent. It is still not certain whether the funds can be recovered, but I only had a few loans of 10 EUR placed with them, so I will survive. And more importantly, it hasn’t discouraged me from investing in P2P lending.
How do you mitigate the risk of loan originator bankruptcies?
There’s two things you can do to mitigate the risk of a loan originator bankruptcy: research and diversify.
Research involves looking into which loan originators you feel comfortable with. A platform like Mintos makes it easy to see the risk rating of the different loan originators, but on others you might have to dig around on the internet to find more information about the loan originators. You should only invest in loan originators you are comfortable with.
Diversifying your investment across multiple loan originators is always recommended. This way you minimize the risk of losing your entire investment at once.
4. Platform bankruptcy
What is a platform bankruptcy?
If the two previous risks were serious, we are now moving to the very serious category.
The risk of a P2P lending platform going bankrupt is what could keep me awake at night. If a P2P lending platform goes bankrupt, you risk losing your entire investment.
How do you mitigate the risk of platform bankruptcies?
Again, the advice is to research and diversify.
I always research my platforms carefully before I invest money in them. The different platforms are registered in different locations with different accreditations and guarantees. In Europe, some of the platforms might have accreditations that require guarantees of your investments up to certain amounts.
It is always wise to read up on the latest news about the platforms and to check their financials and the team behind. Is it an experienced team making money yet or is it a startup struggling to pay the bills every month?
I invest in more than six different P2P lending platforms to diversify the risk of platform bankruptcies, and so far I am not concerned about any of those platforms.
5. Geo-political and -economic problems
What is geo-political and -economic problems
If we look at P2P lending from a helicopter point-of-view, investing in crowdlending comes at the same risk other investments do, for example financial crises, political changes and even wars.
We have not seen how P2P lending performs when the financial markets crash big-time. When many borrowers must default on their loans at the same time because people are fired by the millions as happened in 2008. My guess is that some of the loan originators and platforms might not survive a crash like that, but I might be wrong.
P2P lending is also a risk in terms of political changes. For example, it might become less attractive for Europeans to invest in UK-based P2P lending platforms following Brexit.
Lastly, the world can turn ugly and if disasters such as wars erupt, then your P2P lending investments (or any other investments) will most likely not be safe.
How do you mitigate the risk of geo-political and -economic problems?
This one is tough and in many cases you probably can’t do anything.
You could consider investing across various regions, but I guess the best answer is to never invest more money than you can afford to lose.
If serious political trouble or even wars break out, then I believe you might have bigger worries than what to do with your P2P lending investment. If you want to mitigate this risk, you could keep some physical liquid assets in the form of cash, gold or similar.
6. Ethical concerns
What are ethical concerns associated with P2P lending?
The last risk is of a different character and is more non-financial. You will most likely not lose your investment over ethical concerns.
However, a risk with investing in P2P lending is that it is not always fully transparent what your money is funding. Is it going to individuals who understands the concept of interest rates and to businesses with ethical business pursuits – or the opposite?
The lack of transparency is the same when you invest in stocks. What do the business do with your money? Pollute the environment, exploit workers in developing countries or worse?
How do you mitigate the risk of ethical concerns?
You can research the companies behind the P2P lending platforms and most often the individual loans also offer detailed information about the borrower, but to be honest, you will most likely never get full transparency on this.
I have decided to trust in selected P2P platforms to do the appropriate due diligence and the European regulators’ oversight of these companies. Is it enough to be 100% free of the ethical concerns? Perhaps not.
Should the risks keep you from investing in P2P lending?
Maybe. If you cannot afford to lose your whole investment, I would not recommend you invest in P2P lending.
If you have some money to invest at potentially high returns (+10-20%) that will not ruin your life if you lose, I would consider investing in P2P lending.
Personally, I invest about 5-10% of my assets in P2P lending always respecting that it is a high risk, high return investment. For my current average returns of ~13% pre-tax, it is a risk I am willing to accept.