The fact that Peer to Peer (P2P) links investors directly to borrowers without a banking intermediary can allow for many benefits to the investor.
By cutting out banks and similar institutions, P2P platforms aim to offer far better rates of return for investors and lower borrowing rates for borrowers. However, with this direct connection there is a risk that should a borrower miss a payment or default on the loan, your investment could be at risk.
So how do P2P platforms seek to protect your investment by minimising this kind of risk?
1) Assessing borrower risk
Borrowers are often subject to incredibly strict criteria to determine their level of risk. Most platforms have their own threshold which borrowers must reach before they’re accepted. The borrower is then subject to a risk profiling process which gauges their potential risk based on a number of factors including the nature of the loan, their age, employment status, any outstanding debt and their credit score.
Credit checks are sometimes made in conjunction with one of the UK Credit Reference Agencies and reviewed in great detail based on their debt, financial and borrowing history.
If the applicant is accepted, they are given a risk factor score which is then used to pair them with investors who are willing to accept that level of risk. Be aware that not all platforms make these scores available to borrowers. However, all P2P companies have a vested interest in bringing only the highest quality borrowers onto their platforms.
This process means that often the relationship between investor and borrower is completely transparent. As an investor, you’ll more than likely be aware of the borrower’s history and potential risk which you can then take into account when you’re choosing whether or not to invest in them and the platform.
2) Spreading your investment
Some account-based Peer-to-Peer platforms seek to spread your investment automatically across a large pool of borrowers, diversifying your investment and therefore lowering your risk. However, if you invest in self-select loans, you will not get this automatic diversification.
Regardless, in both self-select and account-based investments, we recommended that you invest in at least 10 different borrowers, often more. As the amount invested in each borrower is only a small percentage of your total investment, you should be covered by the interest gathered from your other investments if a borrower defaults or misses a payment.
In some cases, P2P platforms will take out security against the borrower to ensure that your investment is safeguarded. Wellesley & Co and Assetz Capital for example only participate in asset-backed lending which secures the total loan value against an asset.
If the borrower doesn’t pay back their loan, these platforms will sell the asset to cover the shortfall, in addition to any other security in place. Be aware that not all P2P platforms do this so check with the provider and make sure you read all the fine print before you invest.
4) Provision Funds
A Provision Fund is a pool of money (normally a fixed percentage of the total loan book) that allows a P2P platform to pay an investor any missed interest if a borrower defaults or if a payment is missed. In most cases, Provision Funds are run by separate legal entities (e.g Assetz Provision Funding Limited) to the actual P2P platform and are built from charges taken from the borrower’s interest repayments. They can also in some cases be pledged by credit insurance and asset security from third parties.
Companies like Ratesetter, Landbay, Wellesley & Co and Assetz Capital all provide a form of provision fund.
Some P2P companies also take out insurance against the loan, either as a standalone protection or a further layer of protection. For example, the Lending Works Shield
works in combination with their reserve fund (a provision fund) to protect against borrower default thought cybercrime, fraud, sickness, death, redundancy or loss of employment on the part of the borrower.
Other companies such as ArchOver use credit insurance on accounts receivables, which means insurers can pay out to investors as the ‘loss payee’ and the debt collection is take separately, if any invoices go unpaid. Credit insurance can also be used to help make decisions when assessing borrower risk.
That’s not to say that a platform without a Provision Fund is necessarily riskier than one with a Provision Fund. The platform may take out another form of security such as an asset as discussed above.
Platforms with Provision Funds often have lower rates of return than ones without as Provision Funds require overheads such as staffing and administration costs.
Even if your platform of choice does have a Provision Fund, that doesn’t mean you’ll necessarily get any or all of your money back in the event of a loan defaulting – so don’t bank on it. Provision Fund Managers will assess each claim and determine whether you’re eligible to be repaid in part or full based on their own criteria.
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