One type of investment that is increasing in popularity among investors is peer-to-peer, or P2P, or social lending. Web-based p2p lending sites that connect people looking to borrow money to people looking to lend money become everyday more popular among the investor’s community. Thinking of P2P lenders as merely lenders masks the complexity of their role. On P2P lending sites, a lender is both a lender and an investor because, as in any investment, there is risk in peer-to-peer lending.
On its face, social lending would seem to be a safe bet since the lending process occurs between individuals rather than between a borrower and a large impersonal bank. The benefit of peer-to-peer lending was best stated by Barney Frank who recently said this in the context of regulating securitization:
If I lend you money and I expect to be paid back, I’m going to be more careful than if I lend you money and you’re going to pay back somebody else. And securitization has weakened that borrower/lender relationship and the discipline…. We think you need to put some limits on securitization. People should not be able to lend money without having any risk retention.”
Even laypersons who know only the basics of P2P lending understand its main benefit: accountability on a small personal scale:
Goodbye ‘Too-Big-To-Fail-Unaccountable-Banks’ Hello Accountable Peer-to-Peer Lending.
While it’s true that a peer-to-peer loan is not a securitized loan, and that they are far more “personal” than the loans offered by large banks, this doesn’t mean these social loans are less risky than other types of investments. On the other hand, it doesn’t necessarily mean that they’re more risky either.
The Risks of P2P Lending & How to Measure & Minimize Them
There is a clear risk inherent in any kind of lending, and that risk is default. However, like any potentially good investment opportunity, there are several ways to minimize this risk. When an investor is looking for borrowers, they should select those that have good credit ratings, low debt to income ratio and a low number of credit inquiries on their records. Never having a delinquency is another good sign. Also, all else being equal, you should look for borrowers that are requesting relatively smaller loan amounts and focus i on borrowers credit record and ability to repay. As a general rule of thumb, you should only invest what you can safely afford to lose, but – that goes for any investment.
P2P lending sites have one great built in mechanism that helps minimize risk. Lenders can, indeed, they are encouraged, to lend to multiple borrowers instead of one or two. This spreads the risk out and is one the great advantages of P2P investing.
Another great way to minimize risk is to do as Peter Renton of sociallending.net suggests: get educated about investing in general and P2P lending in particular. For example, the knowledgeable P2P lender will look at a high return (high repayment interest) loan not as just a great potential investment opportunity but as a real measure of default risk. Of course, this is no different than any other investment opportunity, i.e., the higher the potential return, the higher the risk.
In sum, P2P lending is a great investment vehicle, and as every rewarding investment, it comes with risk. Investors are advised to become as educated as possible to take best advantage of this unique investment opportunity.