Like any other investments, Peer-to-Peer lending comes with a set of risks. Being a relatively new form of investment, it is good to know the risks of P2P lending and how to go about it.
Peer-to-Peer lending risks
There are several different risk factors in all kinds of investing. We have collected those that we believe are major risks for any P2P lender.
You are your worst enemy in any type of investing for one simple reason. You are a creature of emotion. We all are. Fear and greed have even gotten the worst out of some of the best financial thinkers throughout history, which have led them to financial ruin.
Therefore, it’s important that you invest with a reasonable level of risk in mind. When you start investing in P2P lending you should always make a plan for what you think is the right risk/reward level for you.
This is harder to do later on, as you will get blind toward the risks, as your perceived level of safety increases. This will potentially make you take on more and more risk. It happens due to a cognitive bias called risk compensation or the Peltzman effect.
Investors are often prone to a list of cognitive biases. We highly recommend that you go study the different cognitive biases, as knowing yourself is key to successful investing.
2. Platform risk
If a P2P lending platform you use goes bust, it will take a lot of time to retrieve your money – if any. The chances that you get your money back due to a bust depends on the nature of the bust itself. In the worst case, you can end up without getting any money back.
It may not be the most likely thing that your P2P platform collapse. But it is a possibility you should account for when assessing the risks involved in peer-to-peer lending.
3. Credit risk
Credit risk is probably the most common of the peer-to-peer lending risks. Basically, credit risk is the risk that a borrower can’t repay their debt.
As a rule of thumb, you can expect the interest of the good loans to be sufficient to cover for failed loans as well as providing you with a return. This is however not a guarantee. Especially in times of recession.
The credit risk will in times of recession and during financial crisis increase, as more people probably will default on their debts.
Sometimes credit risk can be avoided if the platform you invest through offers a buyback guarantee.
We have now addressed some of the most common risk factors in P2P lending. Read on to learn how to lower P2P lending risks without compromising your return.
How safe is P2P lending
How safe P2P lending is, highly depends on how you go about tackling the peer-to-peer lending risks you will face. Let’s look at how you shouldn’t try to tackle the risks.
The unsafest way to invest in P2P loans:
Let’s assume that you are just starting out doing P2P lending. You create an account on a P2P lending platform. After that, you deposit some money into the account and you are now ready to start investing.
In the worst case scenario, you put your money into just one loan with super high returns. No buyback guarantee – no nothing. YOLO, right?
Now even though you might think your investment is safe on a fairly good platform, it isn’t. And even though the platform you invest on is fairly good, you have committed nearly every mistake possible.
Let’s see how the different peer-to-peer lending risks could affect the outcome of the investment:
- The platform could go bust, and you could be left with nothing
- The loan could default, and you would stand with nothing
Luckily it is possible to invest in a much safer way. But in order to make P2P lending safer, you just have to make sure that you don’t take on too much risk.
How to lower your risk
The single most important thing is diversifying your investments.
- Diversify between P2P lending platforms
- Diversify between loans
- Use buyback guarantee
Diversification between platforms is probably the most overlooked way to lower risk amongst P2P lenders. However, it’s probably one of the most important as the risk of a platform going bust always will be there.
You should always avoid a single point of failure, and therefore the best idea is probably to invest in P2P loans through at minimum a few different P2P lending platforms.
Some P2P lending platforms like Mintos doesn’t make the loans themselves. Instead, they connect the investors with existing loan originators. Here it’s important to also diversify between the loan originators.
Diversifying between loans is another really important aspect of reducing risk in P2P lending. Typically, P2P investors diversify between hundreds if not thousands of different loans. But there is, of course, no reason to over diversifying and only buying for $1 per loan. $10-$25 should be more reasonable, depending on your total amount of investments of course.
If the platform you choose to invest on offers loans with buyback guarantee, you can use this to lower your risk further.
Just remember that the single most important thing in investing is diversifying your investments.
Peer-to-peer lending risks come in various forms. But with proper diversification between platforms and loans, as well as not falling victim to cognitive biases, you should be able to invest with a fairly good risk/reward level.
PS: If you are looking to start investing in peer-to-peer loans, we recommend checking out our review of Mintos. It might be the best P2P lending platform out there.