To paraphrase Crowdfund Insider’s “The Ultimate Crowdfunding Guide,” with peer-to-peer lending, the risk an investor accepts is default. Every P2P platform has its own policy on default, and all investors need to take the time to understand these policies in order to protect themselves.
Because every P2P platform has its own default policy, and because the P2P business model is relatively young, we must be cautious when making generalizations about default rates across peer-to-peer lending platforms. Specific to Funding Societies, we fully aim to keep default rates close to banks – not exceeding 4%-5% of loan amount to secure healthy returns for investors, even accounting for the cost of default.
Because of the P2P industry’s youth, some investors with a low-risk tolerance may view peer-to-peer lending as an unpredictable instrument. Generally too, there is a consensus among investors that P2P lending constitutes a higher-risk, but higher-reward investment.
But is this belief true and valid? Let us take a look at the global trend of default rates in peer-to-peer lending platforms.
Let us start with default rates in USA platforms. In this fascinating Lending Memo article titled “Default Rates at Lending Club & Prosper: When Loans Go Bad,” the author analyzes historical trends of default in these two well-known USA platforms, then draws conclusions about the default rate of the P2P industry.
(Note that the article was published in 2014, so some might find it dated. However, the analysis within is worth a read)
The writer pointed out that from 2007 to 2008, the US economy was doing very poorly and that both Lending Club and Prosper were operating under their earliest, thus most imperfect, credit models, which means the default rates of 2007 and 2008 can be waved off. Since 2010, both platforms have averaged a 5% default rate and are likely to continue having solid repayment rates in the future.
The article ends with a positive conclusion about the P2P industry. The author wrote: “I see refined underwriting algorithms and mailed borrower marketing, encouraged investor capital and purpose-built technology all repositioning itself over and over for the past eight years until they are arrive at the stable place they hold today. I see analysis and sweat and reanalysis in these charts, and in the end I see it culminating into one of the most simple and creative investments our country has ever seen.”
His statement underscores that under the right circumstances, which includes an innovative team and rigorous credit policies, P2P platforms thrives and provides attractive returns while lowering default rates.
Moving on, let’s focus on a well-known and respected P2P financing platform from the UK: Funding Circle. In their statistics page, Funding Circle claims that its average annual default rate stands at 2%. The rate has also remained solid over the years (calculated from 2012-2017), showing that platform maturity and good credit underwriting will stabilize default rates.
What about our own platform, Funding Societies? Here is our own statistics page. Historically, our default rate across the region has lowered overtime, which reflects the analysis of P2P financing platforms in the USA: continuous platform improvement will lower default rates.
Another worthwhile read that talks about the risks in P2P is the recent study released by the UK Peer-to-Peer Finance Association (P2PFA). Some of the study’s pertinent points include:
• Peer-to-peer lending has created more choice in the loans and investment market.
• P2P platforms conduct credit risk assessment using the financial industry’s best practices.
• Peer-to-peer lending does not create systemic risk, and platforms are well-placed to weather a downturn in the credit cycle – borrower defaults would need to increase at least threefold to reduce average interest rates for investors to below zero.
So let’s go back to the question we asked earlier: is the belief of peer-to-peer lending being a higher-risk investment true and valid? Not necessarily.
However, the P2PFA study presented two caveats: that there is a good regulatory framework for the P2P industry and that investors are educated. For the first point, Singapore is getting there (see here) and Funding Societies has always been proactive and compliant towards regulations. For the second point, while there will always be risk of default in peer-to-peer lending, there are ways to mitigate such risks.
How do you diminish your risks? You diversify your investment and reinvest your returns.
Diversification means distributing your funds across as many loans as possible to prevent loss in case of default. The more diversified you are, the more protected your investment. Even defaults hardly disturb your rate of return. If you choose not to diversify, you stand to lose your investments should a default occur.
Meanwhile, reinvestment refers to the act of funneling your investment gains into new loans to maximize your returns. Without reinvestment, you only receive the expected rate of return from a loan. But with reinvestment, you can maximize (sometimes doubling, even tripling) your returns while minimizing your investment risks in case of default. For more information on diversification and reinvestment, see here.
When investors fully understand the risks of peer-to-peer lending and take proper precautions to protect their funds, the advantages of P2P clearly outweighs the risks. In fact, it’s very likely that most investors who keep diversifying and reinvesting their investment will continue to earn positive returns.