Key Considerations in Peer-to-Peer Lending

Now that you have decided to invest in P2P loans, what next? Before you jump right in, there are numerous issues to take into consideration. As the saying goes, “Knowledge is power” and that phrase certainly has meaning when it comes to investing. As with other types of investments or any new endeavor, it may be best to start small before committing any significant amount of capital.

Here are a few key issues that you will want to take into consideration before getting heavily involved in this type of investment:

Loan selection: How do you plan to select the loans you will invest in? There are many different types of loans available, with varying term lengths and credit scores. The types and quality of loans that you select will largely be a function of your risk tolerance, or lack thereof. Before you begin building a P2P loan portfolio, come up with a game plan as to how your funds will be invested.

Risk management: Just like any other investment, P2P lending carries its own set of risks. Just because you have decided to invest in these types of loans does not mean that you should simply ignore the risks involved. Although some risks must be accepted in order to earn a return, a good risk management plan can potentially help to minimize any major shocks to your portfolio. A couple of question to ask yourself are:

  1. How will I try to manage prepayment risk?
  2. How will I try to manage default risk?

Let’s start off by addressing prepayment risk. This is simply the risk the lender takes that the borrower will pay off his or her obligation early.

“Wait a minute!” you are probably thinking. “How can a loan being paid off early and therefore not defaulting be a bad thing?”

Here’s how: A P2P lending loan portfolio carries default risk, or the risk that a borrower will not pay back the loan. This is a risk that must be assumed when investing in these types of loans, and in some cases a default may be unavoidable.

Given the fact that defaults can and do happen, it is imperative that the good loans you invest in return enough interest over the life of the loan to help cover the losses on bad loans you have invested in. When a loan is paid off early, the amount of interest income earned can be significantly smaller, and if the loan is paid off early enough, the amount of interest earned can be negligible.

Not only that, but you must also consider market conditions and the prevailing state of interest rates. A loan made today at a competitive rate may be made at some point in the future at a less competitive rate. In other words, there could be an opportunity cost involved as well.

Default risk is default risk, and presents a much more serious problem than prepayment risk. There are many reasons a borrower could potentially fall behind on their loan and then go on to default. Some of these reasons include a job loss, loss of overtime income, rising mortgage rates or other factors.

Whatever the case may be, defaults are possible and need to be accounted for when building a loan portfolio. You will need to determine your tolerance for risk when building a portfolio, and make your investments accordingly.

One of the easiest and most effective ways to try to manage both default risk and prepayment risk is to diversify your investments.

How will you measure your success? When it comes to investing, it is imperative to have some type of benchmark that you can use to gauge your returns, or lack thereof.

Equity investors may use the broad market S&P 500 as a benchmark index with which to gauge return performance. Measuring returns versus such a benchmark may also potentially be useful for adjusting risk parameters. If you are consistently outperforming the benchmark, perhaps your risk level is on the high side. Conversely, if your returns are consistently lagging behind the index, you may potentially need to reconsider your risk tolerance.

There are benchmarks now available that track relative performance data for P2P loans. One such benchmark is the Orchard US Consumer Marketplace Lending Index. This index is designed to measure the performance of loans made directly to consumers online. The gauge measures performance statistics for the aggregate amount of loans made to consumers from various U.S.-based online lending platforms.

A quick glance at the index may provide you with a simple guide and means of overall portfolio comparison to the broader P2P lending market.

A deeper performance evaluation: After comparing the performance of your portfolio with the performance of a relevant index, you can elect to make some changes in your portfolio going forward based on relative performance. If you are beating the index by a significant amount, you may want to consider taking a closer look at the amount of risk you are taking. On the other hand, if your portfolio is severely underperforming the index, you may want to consider adding more risk within your tolerance.

When taking stock and making such comparisons, it may also be a great time to look at the types of loans that have prepaid or defaulted. If your portfolio has had several loans that were prepaid, you could be missing out on significant interest and may want to scale back on that specific type of loan. Likewise, if you have had multiple loans go into default, you may want to take a closer look at the type of loan and see if there is any pattern. This may help you avoid loan defaults in the future.

P2P lending can provide investors with another vehicle for diversification. That being said, such investments do come with their own set of risks and potential rewards. If you are looking to make P2P lending a significant part of your overall investment strategy, you must do your homework beforehand.