Are you considering the risk of Peer-to-Peer lending? In this article, you can learn about 10 of the biggest P2P lending risks, in no particular order. You will also learn how to manage the risk of P2P lending.
Please note that the list of P2P lending risks is not exhaustive.
1. Credit risk
When investing in P2P loans, there is a risk that the borrower will not be able to repay his loan. If that happens, the borrower will stop paying off the loan and thus default on his debt to you.
If the borrower defaults on his debt, you risk losing the money you have invested. This P2P lending risk is called credit risk.
How to minimize credit risk:
- Spread your investments between many loans
- Invest in loans with a buyback guarantee
You can minimize your credit risk by spreading your investments between many different loans. On a platform like Lendermarket, you can invest as low as €10 per loan. This makes it possible to minimize your credit risk with relatively few funds.
In addition, it can also be a good idea to invest in loans with a buyback guarantee. However, not all P2P lending platforms have a buyback guarantee on their loans.
If you choose to invest in loans with a buy-back guarantee, there is still a risk that the person providing the guarantee cannot fulfill it.
2. Platform risk
When you invest your money through a Peer-to-Peer lending platform, there is a risk that the platform will go bankrupt. This P2P lending risk is called platform risk.
In the event that a P2P lending platform goes bankrupt, you risk not having access to your invested money for a long time.
How to minimize platform risk:
- Choose profitably and regulated P2P lending platforms
- Invest through multiple platforms
The best way to minimize your platform risk is to invest through profitable, supervised platforms.
If you want to invest a lot of money in P2P lending, it can also be a good idea to invest through several platforms at once. Should something negative happen to one platform, you do not risk your entire P2P lending portfolio.
3. Cash drag
If there are not enough loans to invest in on a platform, then you risk that your money is sitting in cash waiting to be invested. This is called cash drag.
Cash drag is not the most important P2P lending risk, as it simply reduces your earnings. However, it is still a relevant risk to keep an eye on.
How to minimize the risk of cash drag:
- Investigate the platform through Trustpilot reviews
- Choose a P2P lending platform with many loans
- Consider using multiple platforms
Most platforms that do not have a cash drag often show a long list of available loan options on their website. Therefore, check whether there is a loan list on the platform.
Before choosing a platform for crowdfunding, it is also a good idea to read whether other users experience cash drag. You can do this on Trustpilot, where many investors are good at telling you if there is a cash drag.
If you have a very large investment portfolio, it may also make sense to use several platforms to minimize this P2P lending risk.
Finally, it is worth mentioning that cash drag can come and go depending on market conditions. Therefore, make sure to keep an eye on whether or not all your money is invested.
4. Bankruptcy of lending companies
Many loan-based crowdfunding platforms do not manage the loans themselves. Instead, they only offer a platform and leave the lending companies to manage the loans.
Here, you will often have a claim against the loan company and not the platform itself, in case things go wrong. This happens e.g. applicable on a platform like Mintos.
Many lending companies offer a buyback guarantee on the P2P loans that you can invest in on the platform. But in the event that the loan company goes bankrupt, the repurchase guarantee will not do much and you, therefore, risk losing your money.
How to minimize your risk in the event of bankruptcy of loan companies:
- Be aware of where you have your risk
- Investigate how solid the loan companies are
- Invest in loans from several loan companies
First of all, you must be aware of who you have a claim against if things go wrong. Is it the platform or the loan companies?
If it is the loan companies, you should always investigate how solid the individual loan company is. You can do this by examining accounts, reviews, ratings, etc.
No matter how solid a loan company looks, it is also a good idea to spread your investments between several loan companies. In this way, you minimize your risk to the individual loan company.
5. Inflation risk
Inflation reduces your purchasing power. This is because inflation causes prices in society to rise. This means that your money is worth less and you can actually buy less for the same money.
High inflation is a risk for the P2P investor. This is because inflation makes your investment and the rents you receive worth less when you measure what you can get for the money.
Let’s assume that inflation is 2% and you get an 8% return on your P2P investment. In that case, after your investment period, you will be able to buy 6% more for your money than before you invested. It is, of course, before tax.
If inflation rises to 8% and you get an 8% return, your purchasing power does not increase. But since you have to pay tax on your return, you actually end up with a negative return when you measure what you can get for the money.
Inflation affects all investments. But it’s still a P2P investment risk you’ll have to deal with.
How to minimize your inflation risk:
- Invest in short-term loans
- Short-term loans are less vulnerable to rising inflation than long-term loans.
The interest rate on new loans is determined based on the level of inflation plus a risk premium for lending money. If inflation rises, the interest rate on new loans should also rise.
But for the existing loans, the interest rate does not increase. Therefore, it is not good to invest in long-term loans when there is rising inflation.
With increasing inflation, it can therefore be smart to invest in short-term loans. One of the best platforms for short-term loans is PeerBerry.
Conversely, falling inflation can give P2P investors an opportunity to keep a high rent for a long time, by investing in loans with a long maturity. Therefore, falling inflation is good for long loans.
6. Liquidity risk
Many crowdfunding platforms in Europe allow you to sell your loans before they expire.
In some cases, you can sell the loans directly back to the platform. In other cases, you can sell them to other investors through a secondary market.
Although there is a secondary market on the platform, it can take a long time before you can sell your loan. The P2P lending risk is called liquidity risk.
The risk of a lack of liquidity is that your money may be tied up on the platform for a longer time than you expect. This is especially a problem if you need to use the money or find other good investment opportunities.
How to minimize your liquidity risk:
- Avoid investing money that you will need soon
- Choose a platform with an active secondary market
- Choose a platform that focuses on short-term loans
First of all, it is a bad idea to lend money if you know you will need it soon. Because even if there is a secondary market, it can take a long time before the loans are sold and you get the money.
In addition, it is a good idea to choose a platform that has a secondary market with many active investors. A good bet for that is Mintos.
If you don’t want to depend on a secondary market to raise liquidity, it might be a good idea to choose a P2P lending platform that focuses on short-term loans. Short-term loans are often paid within 1-2 months. A good choice for a platform for short-term loans is Esketit.
7. Risk of fraud
Unfortunately, many financial products attract scammers and fraudsters. Therefore, the risk of fraud is a real P2P lending risk that you should consider.
In recent years, hundreds of new P2P lending platforms have appeared on the market. The vast majority are made by serious companies. But there is still a risk of encountering rotten vessels.
How to minimize your risk of being scammed:
- Be aware if something seems too good to be true
- Check if the platform is supervised
- Choose a platform with high seniority
You should be aware that a platform has very aggressive marketing. It may be that the platform only tells you how big a return you get without pointing out any kind of risk.
In addition, you should be aware of whether the platform is supervised by a financial authority. In many cases, authorities will discover fraud sooner or later.
Last but not least, it can be a good idea to choose a platform that has many years behind it, instead of the one that came on the market last month. Although scams can last for a long time, the likelihood that it is a scams will decrease over time.
8. Currency risk
If you invest in loans in a foreign currency, you risk losing money (or earning) from currency fluctuations.
If you invest in a loan that is based on foreign currency, you run the risk that the foreign currency will fall in value against your base currency during the investment period. If that happens, you will ultimately get a smaller or potentially negative return.
How to minimize your currency risk:
- Invest loans based on stable currencies
The best way to minimize this P2P lending risk is by investing in currencies that follow the Euro closely.
All other things being equal, the currency risk from investing in loans denominated in larger currencies will be lower than for smaller currencies.
9. Changes in law
With all investments, there is a risk that the legislation will change.
In relation to P2P lending, the biggest legal risks are probably that there will be more regulation in the area or that the tax will change.
More regulation in the area may change which P2P lending platforms are the best to invest in.
Tax is a P2P lending risk that can be difficult to deal with without moving to another country. But if the tax on P2P lending changes, it can affect your return.
The legal P2P lending risks are mostly about whether it is more advantageous to look for other investment opportunities.
10. Risk of recession
A recession affects most investments negatively. P2P lending is no exception.
When the economy is in decline, the risk that borrowers cannot repay their loans increases.
In an economic downturn, you run the risk of an increasing number of borrowers defaulting on their loans. It will lower your real return on your P2P investment portfolio. The return may even be negative.