Peer-to-peer lending platforms carry some lesser-known – but no less real – risks that investors should know about before they commit.
Monetary Authority of Singapore (MAS) Director Ravi Menon has warned of a “hype” in Fintech. One of these types of businesses, which has been gaining steam of late, is the Peer-to-Peer (P2P) lending platform.
Promising attractive returns, these websites have drawn investors that range from the affluent to even the lower income. But as with any investing platform, there are risks involved. Here’s what you need to know before getting involved.
What is a P2P lending platform?
A P2P lending platform serves two purposes.
First, it provides an alternative source of loans, besides the traditional banks and financial institutions. Some P2P platforms lend only to businesses, whereas others lend to almost anyone – from businesses to causes to individuals.
Second, it provides a source of high-risk, passive income for investors. When you put money into P2P lending, your cash is loaned out to businesses and individuals. You then make money off the interest rate charged (which can be as high as 12 per cent per annum, sometimes more), after the P2P platform takes its cut.
At this point, you can probably see the main danger of P2P investing: that’s the possibility of default. If a borrower fails to pay their loan, the investors would lose some, or even all, of the money they’ve loaned.
However, there are some risks that are less obvious.
1) Borrowers May Restructure Their Debts, or Default on Them
Just because there are few or no defaults among borrowers, that doesn’t mean a P2P platform is “safe”. You have to consider that, when a borrower can’t meet their obligations, they may restructure their debt.
The most obvious example is a debt haircut – this is when a borrower wants to pay back only a part of what they borrowed, such as 80 per cent of or 90 per cent of their loan. Most of the time, this means investors don’t really make money – any accrued interest simply makes up for the borrower repaying less.
However, between taking a haircut (where you get some of your money back) and a complete default (where you get back nothing) you probably have no choice but to accept the former. Bear in mind that the owners of a Private Limited business are not liable for debts incurred by their business – they can easily shut down and leave you empty-handed.
Likewise, businesses may use the same threat to lower their interest rate (e.g. give us a lower interest rate than agreed upon, or we’ll close down and pay you nothing).
What outsiders don’t know is that these events don’t register as “defaults”. Hence, a P2P lending platform could be riddled with such incidents, but still present a “safe” front to investors.
2. Inappropriate Money Handling
Many P2P platforms are quite opaque in how transactions are processed. For example, when you put money on the platform, how does the P2P company store the money before handing it to borrowers?
If the P2P platform puts your money in its own bank account, for instance, there’s an added dimension of risk: the P2P company may close down, and simply run off with all the cash it has access to.
Properly speaking, there has to be a third party to hold such monies in trust – the P2P platform shouldn’t be able to access the money you put down, except to transfer it to borrowers via escrow accounts.
But a lot of the time, you won’t know how the P2P platform handles the money at all. You shouldn’t be too quick to assume that all of them are trustworthy. If you’re serious about investing, at least find out how your money will be handled.
3. Demand and Supply Imbalances
Also called a “cash drag” effect, this is something that banks and financial institutions also have to contend with – there are times when the number of investors greatly outnumber the potential borrowers.
For example, during a period of low interest rates, many borrowers may be more inclined to turn to conventional banks. At the same time, many investors will turn away from banks, as the low interest rates mean they will see limited returns.
At such times, alternative financing platforms – such as P2P lenders – may have far more investor cash than they have willing borrowers. This can cause “cash drag”, in which excess monies are left uninvested (and therefore not earning any interest). This can lower the returns of investors, who would be better off finding other financial products.
4. Liquidity Risks
Remember that, when you put money on a P2P platform, you are not buying any assets. You are giving out loans. This creates a liquidity risk.
You cannot demand that a borrower instantly repay its loan, just because you’re facing an emergency. You need to wait month after month, while the borrower slowly makes repayments. Your money is completely tied up throughout this period, so you must be sure you don’t need it.
This is different from a bank’s fixed deposit (where you can make last minute withdrawals, even though there’s a penalty), or from stocks or unit trusts which can be sold in a matter of days.
Some P2P platforms mitigate this risk, by making it possible for you to sell your loans. However, do check the terms and conditions carefully – such sales may be hard to pull off, or cost you significant fees.
5. Cybersecurity Risks
Due to the large financial transactions involved, P2P lending platforms are attractive targets for hackers. This is doubly true if they don’t handle money the right way (see point 2), and keep the cash in their own accounts.
You have find out what how the P2P platform will compensate lenders in the event that money or crucial data is lost. If you’re required to post sensitive information to be an investor, you should also be wary of the risk that hackers could obtain that same information.
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By Ryan Ong
Ryan has been writing about finance for the last 10 years. He also has his fingers in a lot of other pies, having written for publications such as Men’s Health, Her World, Esquire, and Yahoo! Finance.