I was chatting with a friend of mine over the weekend who has just inherited a small amount from her grandfather’s estate. She knew about my involvement in peer to peer lending and asked me if it was a good place for this money. Of course, I told her it was a great idea.
Then she asked me what the risks were and I rattled off a few of the points I mentioned below. But after our conversation I realized that I had never done a post detailing the risks of p2p lending and it is most likely one of the first questions potential investors will ask. So here it is.
The prospectuses of both Prosper and Lending Club go into great detail (over 20 pages each) about the potential risks of p2p lending. While I encourage everyone to read these prospectuses I realize that few people will take the time. So, here are the five main risks as I see them:
1. Borrower Defaults
When you invest in borrower loans these are unsecured loans, meaning there are no assets backing the loans (such as a house in a mortgage loan). So, if a borrower defaults on the loan there is little an investor can do. You just take the loss of whatever amount of principal is left unpaid. With p2p lending default rates averaging around 3% a year, most investors will encounter defaults at some point.
2. Poor Loan Diversification
The best way to mitigate the risks in point one above is to carry a diversified loan portfolio. By that I mean you should invest in a large number of notes. Let’s say you have $5,000 to invest. It would be a huge mistake to invest in five different loans of $1,000 each – if one of those loans defaults you will lose a good chunk of your money. That is poor diversification. It would be much better to invest in 200 different notes at $25 each, so one default will not impact your bottom line very much.
3. Bankruptcy of Lending Club or Prosper
Both Lending Club and Prosper are losing money. They are still many months (or possibly years) away from breaking even. Even when they start to make money there is no guarantee that they will continue to do so. In the case of a bankruptcy, both companies have a backup loan servicer that is expected to continue processing borrower payments. But there is no legal precedent for a bankruptcy of a peer to peer lender so no one knows exactly what would happen. Having said that both companies are on strong growth trajectories so I see a bankruptcy of either company as unlikely, but the possibility will always exist.
4. Interest rates may rise
We are currently in the midst of the lowest interest rate environment in many decades. Eventually interest rates will rise and the impact this will have on p2p lending is unknown. Right now, it is relatively easy to attract investors with expectations of returns of 8-10% or more. But a few short years ago investors could get FDIC insured returns of 6%. If we return to an environment like that investors may leave for safer returns elsewhere. As an aside, this is why I find the lowest interest rate notes unattractive. An A1 rated 36-month loan at Lending Club or a AA rated 36-month loan on Prosper will yield less than 5% for investors. In two or three years time you may well get an FDIC insured account at a higher rate than that.
5. Regulatory changes
Peer to peer lending is still a new industry and the government doesn’t quite know what to do with it. Lending Club and Prosper are regulated by the SEC in a similar fashion to stock brokers and investment banks (institutions that have little in common with p2p lending). While there has been talk of regulatory changes nothing has happened yet. There is, of course, a slight possibility that the entire p2p lending concept could be legislated out of existence but that is something I consider highly unlikely.
Almost all investments carry some level of risk.While the risks are important to consider, I like to focus on the risk/reward equation. As an investor are you being compensated for the level of risk you are taking? With p2p lending I believe the answer is yes. My friend also agrees and she is going to start investing this month.
What do others think? Did you carefully weigh the risks before investing?