The risks of peer-to-peer lending that can actually result in monetary losses fall broadly into three distinct categories. The following presents a list of the main types of risk for peer-to-peer lending losses and some simple but very effective ways to reduce these risks, in order of priority. In general, before you invest in this risky asset type, you should educate yourself about peer-to-peer (P2P) lending.
P2P credit risk 1: Loss due to bad loans (credit risk)
This P2P risk is probably the most “common” reason for losing money on some loans: when your borrowers are not solvent enough and cannot pay back your money. This is called “credit risk.”
Of all the risks we face in peer-to-peer lending, this is the one we spend the most time evaluating.
When loans go bad, you generally expect the interest you earn from your good loans to be enough to cover any losses. Sometimes there are additional coverages as well. For example, the loans might be secured by the borrower’s real estate. Or the P2P-lending site might have set aside a pot of money to pay for expected bad debts.
However, in extreme cases and with weaker peer-to-peer lending offerings, if a sufficient number of loans default, this could undermine all these protections, leaving you with a loss. So, the risks vary greatly from one P2P site to another.
How to minimize credit risk with peer-to-peer lending.
You want to see the P2P lending site focus on either very high-quality borrowers or prime collateral, which means, for example, low loan-to-value or low past losses that can be easily absorbed by interest.
The P2P lending website should be transparent about their statistics, especially bad debts, and have a good enough history for you to make a judgment about them.
P2P credit risk 2: You yourself (psychological risk)
When you ask yourself, “How risky is peer-to-peer lending?” the answer often boils down to how much you take a step back, calm down, and look at the facts when making credit decisions. It’s more about you than anything else.
The biggest risk in peer-to-peer lending – as with any type of investment since time immemorial – has always been what happens inside our own heads: We get greedy when we should be cautious; we get scared when we should be greedy. We call this “psychological risk.” Those who rub their hands with greed over the money they could make tend to be more active investors, trading, buying, and selling more regularly.
However, the vast majority of people who actively try to take advantage to increase their returns actually do much worse than others who can control peer-to-peer lending risks with passive investing from afar. Investing is quite simple if you’ve only studied it enough to understand it. It’s greed, fear, and pride that get you down.
How to avoid psychological risks in peer-to-peer lending.
For all risks in peer-to-peer lending, there are very simple ways to counter or minimize them.
For psychological risk in P2P lending, your solution is to ignore the crowd, the experts, and what the P2P lending sites chant about doom or euphoria and set some standards of your own that are easy to follow.
For example, for real estate loans, you could set simple rules like: Only lend on properties that are rented by experienced landlords. Any loan must be less than 80% of the property value. The rent the landlord receives must be at least 1.25 times the total loan repayment (mortgage) for each loan.
Follow the rules carelessly – even if some P2P lending sites themselves do not.
P2P lending risk 3: insufficient diversification (concentration risk)
If you lend to a single borrower, it doesn’t matter how brilliant the P2P lending site is at evaluating loan applications, you could have bad luck and lose all your money. (Unless there’s a reserve fund to cover losses, but that’s another story). This is called “concentration risk.”
How to avoid concentration risk in peer-to-peer lending.
This risk can be reduced immensely by splitting the money you lend across a large number of different loans. This is statistically appropriate for automated bank-like loans. The safer and more solid the type of lending you do, the fewer loans you will need. The impact of dividing your money in this way is enormous.
For example, spreading your money across 100 prime real estate loans reduces the risk of suffering large losses from bad debts to a tiny fraction of the risk compared to lending to just one borrower.
In addition, you should also spread your money across multiple peer-to-peer loan providers. This not only reduces the risk of suffering losses from bad debts, but also other peer-to-peer lending risks, such as the risk of losing money because a P2P lending site goes bust or, worse, acts fraudulently.
With these 3 different types of P2P loan risks, we hope to have given you a good overview. These are by no means all the risks, but if you have these 3 risks on your radar, you can significantly reduce your risk of loss in P2P investing.