Peer to peer lending emerged in the UK in 2005. Since then, it has been gaining popularity, and investors consider it mainstream finance. It helps individuals to borrow and lend money without involving any conventional financial institution or bank. It brings borrowers and lenders together at an online platform where all the processes are completed without any hassle. P2p platforms act as intermediaries and do all the hard work for you. These platforms earn money by charging fees from the borrowers and investors. In this low-interest environment, every investor is looking for an investment option that can offer high returns. You can invest in peer to peer loans to make steady and attractive returns. In addition, you can also earn tax-free interest by investing through Innovative Finance Isa (IFISA).
Although p2p investment offers numerous benefits, like all other investments, it comes with some risks that are essential to understand. If you understand the involved risks, you can take measures to mitigate them and invest wisely to make maximum profit. Let’s take a look at the risks involved in this investment.
Types Of Risks
There are three significant risks that you must consider when investing in p2p loans.
Credit Risk
The most significant risk involved in p2p investment is the risk of losing money. Here you are lending money directly to the borrowers. So there is always a risk of losing money if a borrower is not able to repay the loan amount. It is known as borrower default, which can result in loss of all the investment if you have invested money in a single loan. When you deposit money in your p2p account, there are two possible outcomes:
- The borrower repays the loan amount with the interest rate on time, and you receive your capital and the profit in terms of interest.
- The loan repayment is delayed due to any reason. After a specific time, this loan is referred to as bad debt and there is the risk of losing money. However, some platforms reimburse the amount that investors lost due to defaults.
It is better to select a contingency fund platform to cover the default loans. Other than that, you can reduce the risk of default by spreading your investment across multiple loans. In this case, if one borrower defaults, you can continue earning profit from the other loans.
There is also a risk associated with exchange rate fluctuations and fees that you have to pay when making transfers. Therefore, you should do research and choose a platform that offers an affordable rate for currency exchange.
Loan Originator risk
Some small companies are working to manage the borrowers for p2p platforms. These companies are known as loan originators. They are responsible for finding borrowers, collecting interest payments, and ensuring that borrowers will repay loans on time. However, there is always a risk that the loan originator could go bankrupt due to mismanagement of business or a large number of defaults. Therefore, it is always better to look for the financial statement of the loan originator before investing money.
Platform Risk
Another risk in peer-to-peer lending UK is that the platform may go out of business or go bankrupt. It can be due to poor management of loans, a high number of defaults, and a lack of investors or loans. The platform files for bankruptcy in such situations, and you can lose all your money. You should always choose a well reputed, experienced, and FCA-authorised platform to reduce platform risks. According to FCA, p2p lending platforms should put the investor’s money in ring-fenced accounts so that if there is any bankruptcy, the investors can get their money back.
How to Mitigate the Risks?
Of course, lending money directly to individuals and businesses is risky, but there are several ways that can help you to mitigate these risks.
Know the platform
Before investing money, you should understand how online p2p platforms work. By understanding your platform, you know the risks involved and how your money is lent to the borrowers. You can do research, read online reviews and contact successful investors to know about a platform. Always choose a platform with a good track record and an opportunity to diversify and invest in IFISA.
Diversify Portfolio
Diversification is the key to reducing risks in any investment. It is always better to add other asset classes in your portfolio along with peer to peer lending. Furthermore, you can also diversify your p2p portfolio by investing money in multiple loans instead of investing all your capital in a single loan. P2p platforms offer different types of loans, including personal, business, and property loans so that you can invest in various loans as each of them has its own benefit. Through diversification, you can minimize the risk of default.
Select Borrowers wisely
Since p2p lending is a way in which lengthy paperwork is not involved, you should practice caution. Always check the borrower’s profile to know the risk involved, affordability, and creditworthiness. P2p platforms also offer loans to borrowers with bad credit scores, so you must select a borrower according to your risk tolerance. Always look beyond the high-interest rate and consider the risks. By lending money to borrowers with bad credit, you can get high returns, but the risk of default is always high. Therefore, always add borrowers with varying risk profiles to your portfolio.
Remain Invested
If you want to earn significant returns, try to remain invested for a longer period. In the beginning, you should invest in short-term loans for 3 to 6 months to get an understanding of the process. Once you understand the process, stay in the investment cycle for at least 1 to 2 years and keep on reinvesting. This way, you can enjoy the benefits of compounding interest and can earn double-digit returns.
Peer-to-peer lending proves to be an excellent alternative investment. It is run by individuals or groups offering attractive returns. But you should not go overboard and invest all your savings. Instead, start from a small amount, and if you find this profitable investment increase your investment gradually. Always keep in mind the risks involved to make informed investment strategies and earn maximum profit.
