Risk types in P2P Lending

Introduction

Before making an investment in peer-to-peer lending, it is essential to have a solid understanding of the dangers involved, just as it is with any other kind of financial choice. Peer to peer lending carries various risks such as market risks, credit risks, P2P Business model risks and more.

In this article, we are going to provide a straightforward and forthright explanation of the risk associated with peer-to-peer lending.

Investing Risks

The risk of an investment is the probability that the firm to whom money is lent may fail to return that loan. The potential for loss on investments and from lending institutions is something you should carefully consider.

Numerous creditors have chosen to stop repaying their loans. Even while peer-to-peer lending platforms have contracts in place with their listed lenders, this is never a straightforward situation. If you're a peer-to-peer investor, you probably shouldn't put your money into such lenders. Risk may be reduced by learning as much as possible about the management team, the key financial indicators, and the portfolio's historical performance.

Before putting money into loans provided by a certain lender, it's wise to familiarise oneself with the lender's parent financial firm. It's better to seek bad press than PR stories from the P2P lending sites where such lenders offer their loans. If bad news were to be made public on a P2P lending platform, it would be too late for investors to withdraw their funds.

You can only depend on yourself and your research skills while engaging in P2P lending. Always question the validity of anything you see online, and consider several viewpoints before settling on a conclusion. Unfortunately, you won't find much open data on the P2P lending market because of the many conflicts of interest that exist there.

Loan originator risk

P2P platforms often work with loan originators as a source of funding. Loan originators are businesses that source new borrowers, monitor their repayment, and collect any accrued interest.

Any loan provider has the danger of failure, whether through an excessive number of credit defaults or poor management. This is called a loan originator risk.

Credit-related risk

Credit risk refers to the possibility that a borrower will not be able to or will choose not to repay the loan, which would result in a default (bad debt). It is one of the most significant hazards associated with peer-to-peer lending and is a primary component in figuring out the interest rate that a borrower must pay.

Even if some defaults are to be anticipated, a sizeable portion of defaults could be brought on by the following factors:

Alterations in the economic conditions (Market Risk) that have an influence on companies (for example, the Recession), personal finances (for example, unemployment), or the value of properties (e.g. house price crash).

Poor procedures on the part of P2P platforms when it comes to evaluating borrowers' credit ratings or the value of their assets as collateral.

Platform risk

There is no protection for P2P lending under the UK's Financial Services Compensation Scheme, in contrast to savings accounts (FSCS). In the event that a financial institution collapses, the FSCS has the ability to pay up to €98,101.22.

The Financial Conduct Authority does mandate that platforms have enough safeguards in place to guarantee that client funds are kept separate and that loan repayments are secured in the event that the platform goes bankrupt. On the other hand, an occurrence of this kind is likely to result in disruptions and delays in your access to your money. Regulations is different countries vary, but most times it assures that there are small platform risks. Platform risks are mostly commonly associated with scams.

Market risk

The term "market risk" refers to the possibility that borrowers' capacity to repay loans might be negatively impacted by changes in the state of the economy.

The risk may be unique to the different kinds of loans that are supported by the peer-to-peer lending platforms. The following are some of the more important ones:

Unemployment rates 

It is expected that the danger of defaulting on personal loans would grow if unemployment rates rise, as they did during the credit crisis that occurred between 2007 and 2008.

The rates of interest 

Investors who are searching for greater returns on their money have contributed to the growth of peer-to-peer lending despite interest rates being at historically low levels. There is a good chance that a rise in interest rates will make peer-to-peer lending less appealing.

The cost of housing 

Loans on real estate are contingent on the valuation and loan to value (LTV) ratio of the property or properties that are held as collateral.

A decrease in the value of the home will result in a rise in the LTV. It will be more difficult to refinance the property in order to pay off the loan & generate a profit, and doing so might result in defaults including losses if the purchasing price of the property is not sufficient to cover the capital plus interest on the loan.

What exactly is diversification, and how exactly does it lower the risks associated with peer-to-peer lending?

The practice of distributing one's wealth among a broad range of different assets held within a portfolio is known as diversification. Diversification is a risk management approach. The idea behind constructing a diversified portfolio is that it will, on average and over the long run, provide greater returns while also reducing the risk that is associated with any one item in the portfolio.

Peer-to-peer lending is connected with a number of hazards, some of which may be effectively mitigated by diversification. If a borrower is unable or unwilling to repay the whole loan amount, investors run the danger of losing part or all of the money that they have given out (bad debt).

Even while every P2P network has procedures to handle and collect bad debt, the resolution of these issues may take several months, and there is no assurance that you will receive all of your money back.