Peer to Peer Lending – What Are the Risks Involved?

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The scarcity of credit for consumers and small businesses has had an undoubted effect on the economies of developed countries around the world. The recent crisis in the banking sector has led to many traditional lenders slashing the number of loans they issue to consumers and small businesses. Peer to peer lending has covered a steadily increasing portion of this shortfall in recent years, and is rapidly becoming a mainstream alternative to traditional forms of lending.

As well as helping creditworthy people obtain affordable credit, this innovative way of lending has given struggling savers a great alternative to traditional savings accounts. A sustained period of exceptionally low savings rates have left savers worried about their diminishing capital. However, by becoming money lenders, an increasing number of shrewd savers have been able to secure a far more impressive return. Whilst there are some clear risks involved in this type of lending, there are ways in which these risks can be reduced significantly which is discussed further below.

What are the benefits of lending via a peer to peer platform?

The clear advantage of lending through peer to peer platforms as opposed to saving with traditional financial institutions involves the returns achievable. If you were to place your cash in a high street savings account, the rate of interest you would receive would very probably be less than the rate of inflation. This would leave your capital diminishing in real terms.

Lending through a peer to peer platform allows you to lend directly to borrowers and take advantage of interest rates that are often more than 10 times the current interest rates being offered by banks. This is possible since the peer to peer platform connects lenders and borrowers directly, cutting out the financial institution in the middle. That means you can actually grow your capital and protect it from the depreciating effects of inflation.

What are the risks involved in lending through peer to peer platforms?

Whilst the returns from peer to peer lending can be excellent, lenders also need to be aware of the possible risks to their investment before committing to lending. The main risks are detailed below:

Borrower defaults

Peer to peer loans are typically unsecured, meaning that the loans are not secured on a specific asset such as a property or vehicle. As such, if a borrower defaults on their loan, due to a change of personal circumstances, this could leave some lenders exposed.

Poor diversification

Having a diverse loan portfolio i.e. spreading your lending capital across a number of different loans helps to ensure that the impact of individual borrower defaults is minimised.

Fraud and identity theft

Online fraud and identity theft are both huge problems for businesses and financial institutions, and they account for millions of pounds in lost investments and purchases every year. If you are lending money to people, the risk of loan payments being made to fraudulent applicants does still exist.

Interest rates

Whilst interest rates are still at record low levels, they are likely to start rising over the next few years. When savers can once again place their cash in savings accounts which deliver healthy, above inflation returns, investment in these social lending schemes could suffer. However, although the impact of general rate rises on peer to peer lending rates is as yet unproven, the benefits and advantages compared with traditional lending, as outlined above, should ensure that these platforms are still able to offer extremely competitive rates of return to lenders regardless of prevailing market interest rates.

Platform failure

Most peer to peer lenders have a back-up service provider who would be responsible for managing the loan book in the event of the company failing. However, there is currently no precedent for this in the peer to peer lending sector so the actual financial impact to lenders remains unknown.

How can you reduce the risks involved?

The best way to ensure your money is in good hands is to select a peer to peer specialist that takes steps to ensure borrower defaults, fraud and cybercrime don’t put your investment at risk.

Lending Works is UK peer to peer lender which only provides loans to prime UK personal loan borrowers. Lending Works will only approve borrowers after they have undergone a stringent application process. A full credit check is carried out by a highly experienced credit underwriting team, and the borrower’s ability to repay their loan is verified through a series of comprehensive income and affordability checks. In addition, applicants with county court judgements, less than three years’ credit history or excessive levels of debt will have their application refused.

Lenders’ funds are ring-fenced from the day to day operations of the company, and used only for providing consumers with much-needed finance. Lenders’ funds are also automatically diversified, with no more than 10% of each individual’s lending capital being lent to a single borrower.

Whilst default rates in the peer to peer lending industry are extremely low, Lending Works ensures your investment is protected against fraud, cybercrime and borrower defaults using the Lending Works Shield. The Shield includes a reserve fund (which covers missed payments and borrower loan defaults) and an insurance policy (which protects against borrower defaults not already covered by the reserve fund, fraud and cybercrime), ensuring lenders receive the returns they expect. Lending Works also has an agreement with an established back-up services provider in the unlikely event that the company no longer existed.

The current financial climate is actually punishing those who look after their money and save for the future. However, utilising the services of a trusted peer to peer lending platform allows you to secure significantly better returns on your investment whilst minimising the risks involved.

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