Peer-to-peer lending: should you worry about default rates?
The concept is simple but remarkably effective. Peer-to-peer sites allow you to lend your money directly to other individuals or businesses. In return you’ll enjoy an attractive interest rate. See YourMoney.com’s Five tips to get started in Peer-to-peer lending for more information.
At times, peer-to-peer accounts have been compared to savings accounts but this can be somewhat misleading. If you put your money into a bank, while the interest rate may not be anything to get excited about, you can rely on the fact that at least some of the money is protected by the Financial Services Compensation Scheme (FSCS). This means that if the bank goes to the wall, the first £85,000 you have saved with that institution is guaranteed.
These protections do not exist with peer-to-peer sites, while there is also the risk of borrowers falling behind on their repayments. As such, it’s important to remember that you could lose money, particularly if the economy starts to struggle.
While peer-to-peer firms are not protected by the FSCS, they do generally have some plan in place to protect investors in the event of arrears and defaults.
Why doing your research is crucial
Neil Faulkner, managing director of peer-to-peer research and ratings agency 4thWay, explains that investors should pay close attention to published bad-debt figures (which cover loan write-offs as well as simple defaults) of the different platforms.
He says: “What counts as sensible arrears or default rates vary depending on the type of lending. As with bank lending, default rates are not constant: a batch of new borrowers one year can lead to twice the defaults of a batch not much earlier. And peer-to-peer lending platforms report bad debts differently and sometimes not in a useful way, so investors need to check out several platforms doing similar loans to get a sense of what it all means and whether it is likely to truly tell you what you need to know about the platform’s record.
“However, there is currently no market-wide issue with high default rates and therefore no cause for panic to investors who have sensibly diversified across lots of P2P lending platforms doing different kinds of loans, and hundreds of borrowers. Investors could, though, keep an eye on individual P2P lending platforms for rising defaults combined with sinking interest rates, and perhaps learn how to decide when or if to stop lending through those platforms.”
So let’s take a look at some of the major peer-to-peer players and what steps they take to protect investors. Before choosing to invest with any peer-to-peer site, it’s important you do your own research to ensure you understand exactly where your money is being lent, the risk checks in place from the peer-to-peer site, and how they handle arrears and defaults.
Peer-to-peer really started with Zopa more than a decade ago. It provides detailed data on default rates on its website dating right the way back to 2005, but the table below provides an insight into its performance over the last couple of years.
When a loan is approved, Zopa makes an assumption about its likelihood of falling into default over the lifetime of the loan, and then revises this default expectation over the lifetime of the loan. Both of these are detailed in the table.
|Year||Expected defaults at origination||Revised projected defaults||Actual defaults so far||Actual arrears (more than 45 days)|
Zopa divides up investor money between many borrowers matching the risk profile specified at the outset by the investor, to spread the risk. If a borrower misses four months of repayments, then a recovery process begins.
Zopa previously used a provision fund called Safeguard, which could cover investors in the event of missed payments. However, it said that when HM Revenue & Customs changed its rules to allow investors to make a claim for tax relief on losses directly, there was no longer a need for the Safeguard fund, so it has started retiring the fund.
RateSetter is another big peer-to-peer name, having been in business since 2011.
It also publishes comprehensive data on its lending business, even breaking it down into the number of loans that are one month in arrears, two months in arrears or at least three months in arrears.
The headline rate to note is that over its lifetime, 98.31% of loans are up-to-date – in order words, around 1.7% are in some form of arrears.
RateSetter has built a Provision Fund to offer some protection against missed payments, which has come from payments made by borrowers, based on their credit status at the time of taking out the loan. Up to now it has ensured that all investors have received the returns they were expecting, though the firm is at pains to point out that this isn’t a guarantee that will be similarly effective in the future.
Funding Circle is a little different in that you are lending to businesses rather than people. Over the lifetime of the site, it says that around 2% of loans have turned bad.
Funding Circle emphasises that investors really need to take diversification seriously when using the site, encouraging investors to spread their money across at least 100 different businesses, lending no more than 1% of your portfolio to each business.
If a business that you have lent to falls into trouble, you will be notified. Funding Circle gives each defaulting firm a colour – red, amber or green – to demonstrate the likelihood of recovery, and this is updated as the firm receives more information.
Lending Works has pushed itself as the safest of all peer-to-peer lenders, taking additional steps to try to protect investors’ cash.
For example, it has taken out an insurance policy – which it claims is the first of its kind in peer-to-peer lending – which is backed by three large UK insurers. This insurance covers investors in the event that borrowers default due to losing their job, becoming ill or even dying.
On top of that, it has a reserve fund, held in a segregated trust bank account, which is topped up from fees and interest charged to borrowers, and is in place to cover missed payments.
To date, Lending Works has an actual bad debt rate of 1.1%.