Peer-to-peer (P2P) lending, whereby platforms bring together people hoping to get a loan and investors looking for a decent rate of interest, is growing in popularity. But while P2P lending may offer attractive rates of interest at relatively low charges, it is a fairly new area and carries a higher risk than investing in more mainstream areas of fixed interest such as corporate bond funds. So with P2P it is particularly important that you can satisfactorily answer the following key questions before you lend a penny.
1. Who's the provider?
It pays to understand who you are dealing with. Is the provider a familiar face in the P2P lending sector or a new kid on the block? What is the ownership structure and exactly how long have they been operating? To help you assess how robust the platform is, it may be worth checking whether any third-party companies have conducted due diligence on the company. Some useful resources include AltFi and P2P comparison websites LendingWell and Goji.
2. Who are the borrowers?
Different P2P platforms tend to provide loans to specific types of borrowers. For example, Funding Circle only deals with businesses, Landbay focuses on the buy-to-let sector and Zopa facilitates personal loans to individuals. However, there are also platforms that take a broad-brush approach - RateSetter, for example, lends to individuals, businesses and property developers. As borrowers have widely varying motives and risk profiles, it's important to understand who the borrowers are and what they plan to do with the money you lend them. The provider should be able to explain this to you, as well as the way in which they monitor how the money is being spent.
3. Are the loans secured?
Secured lending, whereby the loan is secured against an underlying asset such as a property, is generally considered less risky than unsecured lending. This is because it partly mitigates the risk of a borrower defaulting on their loan, as the underlying asset can be sold to recoup all or part of the lender's money. However, the risks of unsecured lending can be mitigated if the amount of money you lend is spread sufficiently across a range of loans.
4. How diversified is the loan portfolio?
The risk that you may not receive all your money back from P2P loans can be significantly reduced if platforms spread investor funds across a broad portfolio of loans. The number varies from platform to platform and over time, so it's worth checking the average number of loans investors are exposed to. Platforms that offer a market meetingplace for borrowers and lenders will tend to diversify as a matter of course, but other P2P platforms such as ThinCats use an auction-based model where lenders individually select which loans they want to make. If this is the case, you will need to make sure you diversify your portfolio yourself.
Kevin Caley, founder and chairman of ThinCats, suggests 20 loans as a good number for building a diverse portfolio of loans secured against assets. "If a platform is doing unsecured loans, the risk of default is probably a bit higher, so you need to be more diversified - in this case I would suggest spreading money across 50 loans," he adds.
5. How good is the track record?
What's the P2P platform's underwriting process and how successful has it been to date? To ascertain this, find out how much it has lent, and what percentage of the loans have defaulted and/or repaid late.
Mark Posniak, managing director of Dragonfly Property Finance, the lender behind P2P lending platform Octopus Choice, says his firm has loaned more than £2bn in short-term loans with a capital loss of under £5,000.
He says that potential investors should ask "how are the borrowers assessed? What sort of credit profiling is undertaken? If loans are secured, what assets are they secured against? How are they valued, and what level of buffer is there in case that value was to fall over the course of a loan? For example, if the loans in a portfolio are made at an average loan-to-value of 60 per cent, that's a 40 per cent cushion for investors' capital in the event of default".
6. Do they have a provisional fund?
Some P2P platforms offer a provision or contingency fund - a pot of money that can be used in the event of default as an insurance policy. For example, Rhydian Lewis, founder and chief executive officer at RateSetter, says none of his platform's lenders has ever lost a penny due to the provision fund.
But Daniel Kiernan, research director at Intelligent Partnership, says it's still important for investors to check the level of defaults the platform is experiencing. "The platform could be really bad at making loans, but nobody realises because everyone is being reimbursed by the contingency fund," he explains. "So I would be interested to know what the default rate was because you're still having defaults. You want to understand how that's working."
7. How is the default rate calculated?
What's the capital loss rate and, more importantly, how does the provider define this? The Peer-to-Peer Finance Association (P2PFA) requires its members to comply with a standard definition of late payment and bad debt. Its definition of borrower default includes any portion of a loan that has not been repaid 120 days following the original loan repayment date and all costs incurred in relation to late repayments.
But not all providers are a member of this organisation, and membership of this doesn't guarantee things won't go wrong. So you should still do thorough research on the loans you are going to make and the P2P platform you are considering before you invest.
Mr Posniak says: "Never invest without asking the P2P lender for its historical loss rate and be wary of lenders that don't openly publish it. Past performance is not a reliable indicator of future success, but understanding it is crucial due diligence."
8. How easy is it to get out?
Lending money is the simple part, but getting out of a P2P loan can be harder. Some providers have a secondary market and others can use their balance sheet to facilitate withdrawals. However, some platforms may lock investors in for the duration of loan terms. To avoid nasty surprises, double check what the conditions are, and if there are any costs or penalties for seeking to access your money early.
Danny Cox, chartered financial planner at Hargreaves Lansdown, says "The secondary market in P2P lending is poor - if you need to get out early, you will most likely lose money as often the only available way is to sell your loan back to the provider."
Mr Kiernan suggests investors ask their potential provider how liquidity is created on the platform and what happens if liquidity dries up, as well as finding out if the provider has a secondary market, and if they do, how big it is.
9. What is the typical loan term?
The longer the average loan length, the greater the potential impact on liquidity and the ability of investors to withdraw their money. Shorter-loan terms mean quicker redemptions, which boosts liquidity, although these could also offer lower rates. So be clear about how long you are able to lock up your money.
10. Do they have full authorisation by the FCA?
P2P lending has been regulated by the Financial Conduct Authority (FCA) since 2014, but the majority of providers have yet to receive full authorisation. Many P2P providers have applied for full authorisation, but the process is taking longer than expected, meaning several simply hold interim authorisation. Only providers who have full authorisation are able to offer the Innovative Finance Individual Savings Account (IFISA), so check whether they have this or not.
"If the provider just has an interim position, that might not be their fault, it might be down to the process they're going through with the FCA," explains Mr Kiernan "But I would be cautious about going all in on a platform that is operating on an interim basis until it has full authorisation, because I wouldn't want the risk that it might not get authorised by the FCA."
