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7 Risks of Peer-to-Peer Loans

Peer to peer lending lets people lend money to others through an online platform. It is becoming increasingly popular; in fact over 66,000 people have loaned out money from these platforms to businesses and entrepreneurs in return for high interest rates of around 6%. However, there are many retail investors out there that arenق€™t sure about this type of alternative financing, as it hasnق€™t been able to gain leeway compared to the traditional lending sector, and doesnق€™t have the same amount of regulatory safeguards. Peer to peer lending can be a great way to both borrow money, and invest money, however it does come with some inherent risks . Here are seven risks of peer-to-peer lending that you should be aware of before deciding to get involved in this type of financing.

There is a Chance That the Borrower Defaults

When you invest money into borrower loans keep in mind that they are considered unsecured loans. This means that there are not any types of assets that back the loans, unlike a house for a mortgage loan. If a borrower defaults on a loan there isnق€™t much you can do to get back your money. Investors simply have to accept the loss of whatever the amount of principal that went unpaid. The peer-to-peer default rates average to about 3% each year, and so if you become an extensive investor then youق€™ll likely run into a default at a certain point in time.

Having Poor Loan Diversificationآ

The best way of lowering the risk of loaning out money is to have a diversified loan portfolio. This means that you shouldnق€™t just invest a large amount into a couple of loans, but instead have a substantial number of notes. For instance, if you have $10,000 to invest it would be a grave error to only invest in 5 loans for $2,000 each, since even if only one of these defaults, you will lose a large chunk of money. It is a much better idea to invest in 200 notes at $50 each, and so if only one defaults it wonق€™t affect your bottom line that much.

The Bankruptcy of the Peer-to-Peer Company

The two main peer-to-peer lending companies, Prosper and Lending Club are slowly losing money. They arenق€™t close to breaking even, and are likely several months or even years away. Once they do start making money there is still no guarantee that they will be able to continue to do so. If one of these companies is forced to declare bankruptcy there is a backup loan servicer that will be able to continue processing the borrowerق€™s payments, however there isnق€™t a legal precedent for a peer to peer lenderق€™s bankruptcy. This means that no one really know what would occur. However, be aware that both companies have a pretty strong growth trajectory, and so bankruptcy isnق€™t too likely.

Interest Rates May Increaseآ

The interest rate environment is currently at the lowest it has ever been in decades. However, this means that interest rates will eventually increase. The impact of this on peer to peer lending is not yet known. Currently, it is quite easy to attract those investors that expect a return of 8 to 10%. Yet, a few years ago investors were able to attain FDIC insured returns at about 6%. If this occurs again in the future then investors may turn their nose at peer to peer for safer returns somewhere else.

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Low Interest Rate Notes Arenق€™t Worthwhile

Due to the previous risk, low interest rate notes tend to not be worth the investors time. An AA rated loan on prosper for 36 months will only gain their investors 5% in interest, and the same goes for an A1 rated loan from Lending Club. In a couple of years investors will simply be able to obtain an FDIC insured account for a better rate than that and a decreased risk.

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Changes in Regulation

Peer to peer lending hasnق€™t matured yet and so the government is still working on how to deal with it. Prosper and Lending Club are both regulated by the SEC in the same way as investment banks and stockbrokers, which are both very different than peer to peer lending. There is a possibility that the entire concept of peer-to-peer lending could be deemed illegal and taken out of existence, however this is something that is quite unlikely

Risk of Default on the Other Side

If you are on the other side of peer to peer lending then there are still risks of borrowing money through this platform. Namely, if you are unable to repay the loan, your credit will take a substantial hit. This is especially risky if you didnق€™t qualify for the highest loan rating, and have to take on a higher interest rate.