Peer-to-peer lending is an increasingly popular alternative to traditional banking. It allows borrowers to borrow money from investors through websites, known as platforms, without going through traditional banks.
Peer-to-peer lending does, however, come with its risks. Being aware of these potential hazards can help you make informed decisions when making your lending decisions.
Credit risk is the potential loss of funds a lender could experience if they extend a loan to a borrower. Lenders use various techniques to identify, measure and mitigate this threat in order to safeguard themselves financially from such loss.
Credit default risk occurs when a borrower fails to make payments on their debt or declares bankruptcy. This can disrupt cash flows and raise collection costs, ultimately damaging the lender’s profitability.
Credit risk quantification is the process of assigning numerical values to the likelihood that a borrower will default on their loan or other debt obligation. Lenders consider factors such as probability of default, loss given default and exposure at default when quantifying credit risk.
Peer-to-peer lending sites operate like marketplaces, connecting those looking for funds with those willing to lend. Once applications are processed and underwritten, the websites collect funds from investor lenders before disbursing it directly to borrowers.
Liquidity risk refers to the ability of a company or individual to meet short-term financial obligations without incurring significant losses. It’s measured through liquidity ratios, which compare current assets (like cash and accounts receivable) against liabilities.
Liquidity risk is especially critical for businesses that rely heavily on financing, since it can affect their capacity to pay debts. Furthermore, companies with cyclical operations may face difficulties as they lack enough funds during times of weak cash flows to cover expenses.
Interest Rate Risk
Peer-to-peer lending, also referred to as P2P lending, is an increasingly popular alternative to traditional loans. This model works by connecting borrowers and investors directly.
Lenders offer small-business loans, personal loans, home equity loans and lines of credit to qualified borrowers. The platform evaluates each borrower’s creditworthiness and assigns an interest rate based on their rating.
Loan amounts may range between $1,000 and $40,000. Unfortunately, they aren’t FDIC insured, leaving both borrowers and lenders vulnerable.
Therefore, banks must understand and actively manage the interest rate risk associated with their business activities. This involves recognizing and measuring exposures to maturity mismatch and rate mismatch, as well as putting in place adequate controls.
Platform risk is one of the greatest hazards associated with peer-to-peer lending. Platforms may charge excessive origination fees and interest rates, which could significantly reduce your profits.
To minimize this risk, look for a lender who is open about its fees and provides detailed loan terms and conditions. Doing so can help you steer clear of unexpected costs that could negatively affect your return.
Peer-to-peer lending is an online alternative that enables people to lend money without going through traditional banks. However, it also comes with its share of risks for both lenders and borrowers alike.
If you make profits from peer-to-peer loans, taxation may apply. This is usually the case in countries where P2P lending is popular, so it’s important to take into account how it may impact your net returns before investing.
In the UK, investing through an Innovative Finance Individual Savings Account (IFISA) offers tax benefits on interest and capital gains – an attractive incentive to get involved in peer-to-peer lending.
Be mindful that some P2P lenders are ring-fenced to protect your money if they fail. This is known as “platform risk.”