Is P2P Lending safe? The risks of investing in crowdlending

I often get the question: Is crowdlending safe? I think it is. However, I have tried to write down the invidual risks of investing in crowdlending here

The safest place to store your money is in your bank account. By keeping your money in your bank account they will be pretty safe.

We all know that, but it is still not appealing for most of us.

Why?

Because the interest rate is really bad by keeping money in a bank account. The interest rate for bank accounts is even so bad that many people will experience that their money is getting less worth year after year because of inflation.

Just consider how hard you have worked for your savings just to see it getting less worth year after year. That is not cool.

The only way to keep up with the inflation – and maybe even turning the savings into profit is by investing the money. The investments can be in stocks, index funds, real estate, wine, stamps or crowdlending, also known as P2P Lending.

But investing money always come at a risk. No matter whether you are investing in stocks, real estate or crowdlending, there is a risk. The risk varies of course after the potential return, but no matter what will investments always result in a risk of some sort.

Crowdlending – or P2P Lending – is no exception.

Many think crowdlending is interesting mainly because of the high return. However, the high return comes with a price often including a higher risk than for instance stocks and real estate. Because as many knows, high returns is equal to high risk.

The risks of investing in crowdlending are not equal to the risks of investing in for example stocks, though, because these two investments are very different in many ways. The only area where these investments basically are identical (in my opinion) is that they often generate a return.

But what are the risks of investing in crowdlending then if they are not identical to the risks associated with investing in stocks?

So when you know what crowdlending is, the next step is to know the various risks of investing in crowdlending and how you can minimize these. I have listed five different essential risks associated with investing in crowdlending. These risks are as following:

  • The borrower can not pay back the loan
  • The loan originator files for bankruptcy
  • The crowdlending platform files for bankruptcy
  • The borrower, the loan originator or the platform performs fraud
  • How will a recession affect crowdlending?

I have in the following sector explained more about these different risks. Furthermore, I have explained how you to some degree can minimize these risks too.

See a brief video containing the various risks or read more about the risks below.

1. The borrower can not pay back the loan

One of the risks associated with investing in crowdlending is regarding the borrower and his ability to pay back the loan.

Basically, you are issuing a loan through these crowdlending platforms to individuals or businesses. As a result, the borrower technically has a huge influence on whether you will get your money again or not.

Because what happens when the person can pay back the loan? Basically, you will lose the money, which has been invested in this respective loan.

However, it is not something I have experienced yet, and it is (in my opinion) not the highest risk regarding crowdlending. If you follow the following tips, then it is (in my opinion) not even a risk.

How to minimize this risk

Basically, there are two things you should do to minimize this risk of a borrower, who can not pay back the money.

The first one is to solely fund loans with a buyback guarantee.

Many crowdlending platforms offer a so-called buyback guarantee. A buyback guarantee is a guarantee that the platform (or sometimes the loan originators) will be buying back the loan if the borrower has not paid back the loan yet.

For instance, loan originators with a buyback guarantee at Mintos will buy loans back if the loan is 60 days late, and sometimes even cover the right interest rate for these days.

I sometimes invest in loans without a buyback guarantee because these loans without buyback guarantee often come with a higher interest rate.

But to be honest, I doubt that the often higher interest is the higher risk worth by investing in loans without a buyback guarantee. By that reason, I am forcing myself to invest in more loans as time goes with a buyback guarantee. Because of that, it is important that you are aware of this to ensure that you only fund loans with a buyback guarantee.

Special next thing you can do to minimize this risk is to spread your investments across many different loans, loan originators as well as platforms. This is always a piece of good advice no matter what risk we are talking about regarding crowdlending. Diversifying your investment is key to a smaller risk.

This is due to the fact that one bad platform, one bad loan or one bad loan originator will not affect your investment in the same way if you have only invested a percentage of your total investments through this platform, loan or loan originator. As a result, your investment in crowdlending will be a lot safer if you are spread across many loans and platforms.

2. The loan originator files for bankruptcy

This takes me further to the next risk associated with crowdlending. A loan originator bankruptcy.

Some P2P Lending platforms facilitate loans from different loan originators. For instance, Mintos, where a platform like Bondora does not use loan originators.

That means that Mintos is only connecting you to the loan originator, which the one who actually loans the money to the borrower. Because of this, Mintos do not have any contact with the borrower.

At the same time, the loan originator is also the one, who gives you the buyback guarantee. If the loan originator later files for bankruptcy, basically then your buyback guarantee, as well as your investment in general, will be nothing worth.

However, the crowdlending platform will often be trying to recover the investments afterwards, why you may get your investment or some of it back. All serious platforms have policies regarding how to handle these bankruptcies to ensure that their users will get their investments back if possible. To recover the most investments as possible is, of course, in the interest of these platforms because it ensures that their users still trust them.

I have never experienced this regarding my investments in crowdlending, and I have only heard of one time, where one of these loan originators has filed for bankruptcy. I do, though, consider it as the biggest risk at the moment associated with crowdlending. Especially if you do not have any crowdlending platforms in your portfolio, who loans the money out themselves, but only uses loan originators.

How to minimize this risk

Even though I consider it as the biggest risk, it is not something which I am particularly worried about. Especially because I have taken my precautions to prevent this from happening.

The first precautions I have taken to minimize this risk is diversifying my portfolio across many platforms, loans and even more importantly: loan originators. I know I talked about diversifying regarding the last risk, but again, it is just very important, because it prevents you from losing your whole investment at once if a loan originator files for bankruptcy.

The next I do is researching. By researching, I mean that I screen every loan originator before investing in their loans. At Mintos, for instance, I check their rating as well as different stats. I even screen some loan originators on the internet to ensure their financial statement is fine and to get a deeper understanding of their business model.

When I am finished with my screening, then I select the loan originators I feel good about, and more importantly: I deselect the loan originators I do not feel good about. By doing so, I ensure I only invest in loans by good and economically viable loan originators.

3. The crowdlending platform files for bankruptcy

You have now minimized your risk regarding bankruptcies for these loan originators. But is that good enough?

Not exactly. We still have the risk of the crowdlending platform filing for bankruptcy.

The risk of this varies from platform to platform. For instance, at Mintos and Bondora, you will most likely be able to continue to receive repayments as well as interest, where you might risk losing your whole investments at other platforms, perhaps most often smaller platforms.

At Mintos, for example, you will most likely have a contract with the loan originator directly, why this loan originator will owe your money whether Mintos exists or not. As a result, you will probably receive all necessary information from the Mintos liquidator or administrator, so you – or an appropriate manager – can continue to get your interest as well as repayments.

How to minimize this risk

Even if it sounds pretty safe as long as you are only using larger platforms, then it is, however, a risk to be taken seriously.

The precautions I have taken to minimize this risk is just as before:
diversifying my portfolio as well as researching the different platforms before investing through these.

Diversifying means spreading my investment across many platforms – just as I have done regarding borrowers and loan originators. By diversifying my portfolio I ensure that one bankrupt platform will not cost my whole investment – only some of it (which will, however, still be frustrating).

Just as I did with loan originators, I also research the platforms as well as their accounting figures, team, reputation and partnerships. Furthermore, I read their plan for how they will handle a possible bankruptcy.

By doing so, I get a good sense of the platform and their ability to run their business. At the moment I am not at all concerned about a bankruptcy regarding the crowdlending platforms I have invested through.

4. The borrower, the loan originator or the platform performs fraud

This is quite an interesting risk. Not a good one, but interesting, because I have not heard of it happening among crowdlending yet. However, it is still a possible risk if a borrower, a loan originator or a platform performs fraud with the purpose to steal investors money.

The most likely outcome concerning fraud occurs if a crowdlending platform performs a so-called Ponzi scheme. Ponzi schemes are (in my opinion) pretty likely to happen in crowdlending sooner or later because investors are seeking high returns in crowdlending – and will maybe, therefore, overlook clear signs on Ponzi schemes in the future.

It does not, however, need to be a platform performing fraud. It can also be a loan originator or even a borrower performing fraud with the purpose to steal investors money. Hopefully, the different platforms will have an eye open for this to ensure that no loan originators or borrowers perform fraud.

How to minimize this risk

At the same time the crowdlending platform, hopefully, will check their loan originators and borrowers frequently to ensure they are not performing fraud, it is also important that you are awake. Again, you must be doing your research regarding the platforms, loan originators and borrowers. By doing that, you will be investing a lot safer.

I am not worried about fraud regarding the big platforms, and the various loan originators on these platforms. However, it is solely because I have performed my own research, why I always think it is a good idea.

5. How will a recession affect crowdlending?

This is a million-dollar question because nobody really knows how a recession will be affecting crowdlending. This is due to the fact that crowdlending first became really popular after 2010, and therefore several years after the latest recession.

Crowdlending may be affected in the coming recession just like stocks and real estate also was adversely affected under the latest recession. That is due to higher unemployment under recessions, why the borrowers might not be able to repay their loans.

Because of many default loans, some crowdlending platforms, as well as loan originators, may go bankrupt, which will maybe aggravate the crisis further.

But to be honest, nobody at the moment knows how a recession will be affecting crowdlending.

How to minimize this risk

I must admit, this is a difficult risk to minimize because if a recession will be affecting crowdlending, it will affect your investments somewhat no matter what.

I have, however, taken my precautions to minimize this risk by diversifying (again a good idea) my portfolio over various loan types, regions and borrowers like individuals and businesses. By doing so, I have spread my loans over many risk profiles. For instance, if a recession most noticeable will be affecting individual loans, then it will only have an influence on some of my portfolio, and not the whole portfolio.

However, it is a risk, where you only have a little influence, so it is not something you can be minimizing entirely. Unfortunately.

Conclusion: Is it still worth investing in P2P lending?

In my opinion: Yes, definitely.

Of course, crowdlending is a higher risk than investing in some stocks as well as real estate or just keeping the money in a bank account. But by doing research and diversifying the portfolio (the two main keywords for minimizing the risk), then the higher return is in my opinion worth the higher risk.

If you do not think the higher return is worth the higher risk, then I would recommend you to stay away from crowdlending. Sleepless nights are not worth a higher return.

Do you still think crowdlending is interesting, then remember to only invest what you can afford to lose.

It is important to mention that I have only mentioned the most essential risks of investing in crowdlending in my opinion. There is for sure other risks, which you may try to minimize as well.

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