Peer to peer lending is a complex form of credit that bypasses traditional lending characteristics. As most people are well aware, driven by ECB policy, the rate of interest available on bank and credit union deposits is extremely low at present. As a result, many people are looking beyond the traditional options to find better yields.
In this article, we examine the topic, risks and more broadly, the considerations for using peer to peer (P2P) lending as an investment opportunity.
What is peer to peer lending?
Generally, from a lending perspective, there are two core parts to the peer to peer business model; those with money and the services (websites) that connect them to borrowers.
As banks and credit union have traditionally acted as the go-between for savers and borrowers, the same happens with peer-to-peer, except the traditional banking model is removed.
For those with cash to lend, there are a number of critical considerations beyond the promise of a yield that may far exceed anything they could earn from money on deposit… or invested in the stock market.
Where the websites come in
Much like the banking model, the websites that connect those with money and those looking to borrow take a slice of the business by way of a fee.
So, while it might sound tempting… banking at your fingertips and all of that, you do need to exercise extreme caution and carry out your own due diligence before you part with your cash.
No deposit guarantee
Peer to peer lending has no safety net; the Deposit Guarantee Scheme does not apply. This means there is no immediate recourse or protection for any monies deposited with a peer-to-peer outfit.
Under the Irish Deposit Guarantee Scheme (DGS), it protects depositors in the event of a bank, building society or credit union authorised by the Central Bank of Ireland being unable to repay deposits. The DGS is administered by the Central Bank of Ireland and is funded by the institutions covered by the scheme.
The DGS protects:
- Depositors if a bank, building society and or credit union authorised by the Central Bank of Ireland is unable to repay deposits
- Eligible deposits up to €100,000 per person per institution
- Current accounts, deposit accounts, share accounts in banks, building societies and credit unions
The Irish DGS protects deposits held at EU branches of authorised Irish institutions. Deposits held with credit institutions that are authorised in another European Economic Area Member State are covered by that country’s deposit guarantee scheme.
Cherry-picking ‘suitable’ borrowers
When it comes to peer to peer lending, not everyone need apply. This is because lending is done on a highly select basis. Through some of the websites that offer P2P you can lend to limited companies, sole traders and partnerships looking for loans of between €5,000 and €300,000.
In such cases, the go-between will do the credit checks on your behalf. For example, there are a range of business credit checking services against which the go-betweens verify who is a good loan candidate (and who is not).
Those can range from single digits to high teens. This is the main attraction of P2P for those with money in search of a strong yield. More often than not, the higher the risk of the borrower, the higher the rate of interest. When it comes to risk, the higher it is, the higher the probability you can lose your money.
Know the risks
All lending is risky. People become ill, company business models change, consumer preferences switch so a business case for a loan today might not be there in 12 or 18-months’ time. If you are thinking about P2P as an investment option to grow your money, consider the following issues carefully.
Brexit uncertainty will linger
Ireland is uniquely exposed as an open economy to the outcome of Brexit. In fact, the period of uncertainty does not end when the UK leaves the EU. Further uncertainty will continue for years as the UK and EU negotiate a future trade agreement. Uncertainty is a death knell for many businesses, especially as it impacts core planning and investment decisions. This has a major trickle-down effect on consumer confidence, spending and ultimately the profit-and-loss for a business.
Deposit or investor protections don’t apply
As we have already referenced, there is no State savings guarantee offered for peer to peer. This means the €100,000 protection under the DGS does not exist for P2P. When you part with your money, you are in a very risky environment. If all goes well, you should get your investment back with the expected rate of return. However, keep in mind that there will also be a degree of risk of loss of investment too. Neither are they covered by the Investor Compensation Scheme in Ireland.
The rate of return is not guaranteed
Some P2P websites quote ‘expected’, ‘projected’ or ‘target’ returns for investors, but the actual rate you get could be less, for example, if part of the money you lent isn’t repaid (and there’s no provision fund that covers it), or if a borrower repays part of your loan early. Losses reduce yield as does early repayment and in a worst-case scenario, reduce or wipe out capital.
‘Dead’ money period
It is important to remember that although you may have transferred money to a P2P account, it may not be actively lent. In fact, what might be confusing for some people is where they view their account and it shows €0 balance yet there is no actual money lent. This is a slight anomaly as you may have ‘bid’ on a loan but it has not been accepted yet. In this case, your ‘bid’ is probably under consideration and therefore not available to be lent to someone else. In this case, no interest is paid while your cash is waiting to be lent out. Depending on the specifics of the case, it might take a few days for your bid to be accepted or rejected and your money to become available to you or accepted by a borrower… and one where you begin to earn!
Solvency of P2P go-between service
Strictly speaking, this should make little difference. For beginners, the loan is between you and the borrower. However, if the P2P service becomes insolvent or went out of business, you are still owed. However, in the real world, with the go-between gone, it might be tempting for some borrowers, in some cases to ask the question if they are “…still liable…” for the debt, your money! It simply adds a new level of uncertainty and complexity you could do without.
The MoneyWhizz bottom line
If you can’t afford to lose it then don’t risk itFrank Conway, Founder MoneyWhizz
It’s your money, protect it. With peer to peer lending, it carries a high degree of risk. It is important to have a detailed and clear understanding of the nature of the businesses and the markets you may be lending to. Also, consider carefully the character and nature of the management team of any business you may be considering. There are a range of services in existence that can expedite your research and provide invaluable detail. What may have been a robust business model the past may be impacted by a series of changes. Also, keep in mind that neither the Deposit Guarantee Scheme or the Investor Compensation Scheme apply under P2P. Finally, ask yourself if you can afford to lose your investment, if not, perhaps it is not for you!
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