Is Peer-to-Peer Lending Safe For Lenders?

The process of money lending has been very profitable for thousands of years, even before computers and credit reports.

For many decades now, it has become especially easy to assess borrowers and decide what interest rates to charge them.

Research from Liberum and data from Trading Economics has shown that credit cards and personal loans in the US and the UK made money for banks every single year for 20 years, even making money during several recessions and property crashes that include the huge 2008 Great Recession.

You can find similar data for a large number of other countries showing the same pattern. There's a reason why banking as an industry has withstood the test of time!

Now, ordinary, bank-type money lending as an investment has opened up to ordinary people like you and me through peer-to-peer lending accounts and other online direct lending accounts.

The first 18 years of the peer-to-peer lending industry went very well throughout Europe, with very few people losing money overall. But lower risk is not no risk! Some people will experience losses. In particular:

• P2P lending will be subject to bubbles and crashes just like every other investment. While you can usually expect a lot less chaos than with the stock market, it's still important that you create sensible strategies in advance, so that your greed doesn't lead you to lend in accounts that are too risky for you.
• Many of those who choose to go for the higher-risk peer-to-peer lending options, rather than the safer options, will lose a lot of money during crashes.
• During extremely awful economic times – think as bad or worse than 2008-10 – even some of the safest P2P lending companies might not prevent every lender from making at least some temporary losses.
• Not all the P2P lending companies have the training and experience they need. Some do not even conduct all the basic credit checks or other checks that you would expect, or they do so with little skill. This means that the risks vary dramatically between them.

So the trick to safe lending is to educate yourself, and then keep your head and stick to sensible, safe lending strategies. Do this and you can expect to do just fine.

What's the safest way?

Perhaps you want to do peer-to-peer lending safe in the knowledge that you're taking the lowest-risk route? There are some specialist P2P lending companies just for you.

The safest peer-to-peer lending providers typically combine two to four of the following risk-reducing techniques:

• Lend your money to very low risk borrowers only.
• Help you spread your money across dozens or hundreds of borrowers. So you normally need an awful lot more than just bad luck to lose much money.
• Your loans are secured against borrowers' properties, which means the P2P lending company could potentially sell a property and pay you back if one of your borrowers can't pay.
• A bad-debt provision fund: a pot of money set aside to pay you and other lenders back if one of your borrowers stops paying.
• Insurance to cover your losses if a borrower is unable to repay due to unemployment or accident.
• Partner companies guarantee to buy your loans back from you if the borrower falls behind payments for 30-60 days.
• The P2P provider takes the first loss of, say 5% or 10%, before you would lose any money.

Most importantly of all…

What all of the safer ones have is plenty of relevant experience from traditional banking, including a good dose of experience in the specific types of loans that the P2P lending company is specialising in.

This will include underwriting (that's the process they use to assess whether a loan application should be accepted) and it will usually also include credit-risk specialists (who model the risks and help design and improve loan-decision making).

Is there a higher-risk, higher-return way?

If you’re willing to take the risk of suffering large losses, you can get far higher interest rates.

You can lend to desperate borrowers willing to pay interest rates over 100%, or to business start-ups with no history, or to first-time property developers. These loans will go bad more often, and so you must expect much higher interest rates to make the risks more worthwhile.

However, all of us at 4thWay feel that the natural fit for most individual lenders is to put more money into the lower-risk end!

This was the second guide in a series of P2P guides

Read our first guide: What is Peer-to-Peer Lending?

Read our third guide: 4thWay's 10 P2P Investing Principles.

See all the guide pages.