P2P lending is becoming increasingly popular in Europe. The capital invested is increasing, as well as the number of platforms. This is good, because the comparability and competition provides a comfortable situation from the investor’s point of view.

However, I keep noticing that many people invest in P2P loans because of the high returns. What they are investing in there is completely unknown. It is also rarely known how a loan is organised and how it is then financed on the platform. So it’s time to go into the subject in detail.

The P2P network actually comes from IT-technology

The term “P2P” is the abbreviation for “peer to peer”. A P2P network is therefore an association of many people with equal rights. They can participate in the network and get involved. Alternatively, they are also equal if they provide capacities.

How can you imagine this in reality?

There are many examples. But often we don’t even perceive them as a network. For example, a flat-sharing community of students would be such a network. At least in a well organized one. If you assume here that each of the five residents, for example, invests 30 minutes of their daily time for the apartment, a network is created.

One invests his time in the kitchen. Another one cleans the bathroom during this time. The third goes shopping, the fourth vacuums the floor and the fifth makes the food.

Okay, I admit that the student community is not a good example. Only a few of them exist in reality. But it’s about understanding the logic behind a P2P network. So the network consists of any number of participants, all of whom contribute to the total capacity. The basic purpose of the network determines exactly what they do.

Creating a decentralized possibility with P2P lending

If one transfers the idea of the network from P2P lending to P2P lending, the picture becomes clearer. After all, P2P lending is all about borrowing money. It is a community that brings borrowers and lenders together. Some have the money that others want and are willing to pay interest on.

The P2P platforms provide the framework in which the community meets. It can predefine which loans are brokered. They also make the corresponding standardised contracts. The P2P platform is the intermediary that earns on every loan that is realised.

For the credit to come, however, it is necessary to create a clear state of information. No investor will give a loan to strangers . In this respect, the P2P platforms take over the work here and check the credit request in advance.

Here every P2P platform has its own procedure. However, they proceed very roughly like banks and are oriented to the assets and income of the potential borrower. If the loan application passes this check, it is made available on the market for investors. With the help of the available data on the loan, they then check whether the investment is worthwhile and attractive for them.

1:1 versus 1:1000 – chances of P2P lending

Your bank will prove your credit request. Of course, you can request several banks for an offer, but the number of banks will be quite small. After the financial crisis of 2008, banks around the world are very strictly organized and controlled. This is a good thing, because the financial crisis has shown what misuse and mismanagement can have for blatant consequences.

However, it also gives the banks a very great deal of power. After all, they can decide what you can do financially. That can be very restrictive. Because the bank decides what you are allowed to do and what you are not allowed to do. And since the banks all follow the same rules and work according to the same rules, your chances after a credit refusal at one bank are often just as bad at the next bank.

Here P2P platforms offer a real alternative. That doesn’t mean that you can borrow money here and get completely into debt. But it does mean that you can ask a community for credit. So it is no longer a bank advisor or a bank that decides, but you many the chances to borrow money. Whether they do depends on how you stand financially and what interest you are willing to pay for the investment risk in you.

How does P2P lending work?

On many platforms you will always find access as an investor and access as a borrower. The platform itself mediates the two interests.

For a loan, the interested party has to submit various documents concerning his credit request as well as his personal situation. These will then be checked and evaluated by the platform. In this evaluation the default risk is determined with the help of the internal guidelines.

More security = low risk = favourable interest rates

A credit request from an already indebted person for consumer purchases on a low income is potentially very vulnerable to default. Consequently, the risk is very high and the interested party has to pay very high interest rates to the lenders.

On the other hand, the risk is much lower if the financial situation is more relaxed and there is sufficient monthly income. It is even better if the prospective lender can demonstrate that his investment has an additional value.

A house, a car, a machine – these are all things that can be sold in the event of insolvency. Thus, the risk of default for the investor is more calculable depending on the value. It is logical that there is less risk here and consequently lower interest is to be paid for the borrower.

Pre-financing through the P2P platform

A few years ago, it was customary for P2P lending to have the loan applications decided by the investor himself. The P2P platform stopped the loan application for the investors. Only when sufficient investors had been found for the total amount within a certain period of time was the loan finally confirmed. If the interest of the investors fails, the time frame expires and the loan application is denied.

Some P2P platforms are still working like this. I’m not saying that this is bad or wrong. From an investor’s point of view, however, there is a gap in which the capital is tied up without being able to generate a return. Imagine that on the day of the loan request you make your money available for the loan.

Unfortunately there are not enough investors in the 30 days. The loan request is cancelled and you get your money back. This is cost neutral, but for the 30 days you don’t get any interest.

In order to close this gap and be more attractive for investors, some platforms pre-finance the loans. This means that, according to their guidelines, they grant the credit and enter into a credit agreement with the borrower. The borrower receives his money and can spend it.

Now the platform prepares the loan and offers it for immediate investment in the P2P market. You as an investor can invest and receive your interest immediately.

Is P2P lending safe?

To answer this question it is important to understand that the return is always the price for a risk. If you don’t understand this, you shouldn’t invest. And even that is dangerous due to inflation. Consequently, P2P lending is just as safe or insecure as other investments.

To be honest, P2P lending has yet to prove itself. This form of investment has been around for a number of years. But the last financial crisis was many years ago. We have yet to find out how vulnerable P2P lending is to a crisis, especially a financial crisis.

In this respect, it is a little more risky than a normal investment in shares or real estate, but I can’t judge whether the value is 0.01% or 10%. A property can also be a good investment today and a bad investment tomorrow, just because the area is changing structurally.

Well-known banks and investors in the P2P sector

A P2P platform in itself does not represent any real value. It acts as an intermediary and provides a marketplace. A place where two different interests can meet and a business can emerge. So the product of a P2P platform is credit brokerage. As advantageous and interesting as this is, as little value it creates.

What happens during financial crisis?

The vast majority of the population turns their invested capital into liquid money in their accounts. Shares, real estate and other assets are sold to reduce losses. As a result less people would probably invest in P2P lending. There may also be fewer credit requests.

Some platforms, however, work with different banks here. Especially in Scandinavia there are some banks that provide money to the platforms. For example, to pre-finance loans so that more investors can invest their money on the platform. This in turn means more income for the platform.

In the end, the credit agreement counts

Every investment in a P2P loan creates a contract between the borrower and the lender. A financial crisis does not change this. If we imagine that a platform on which you have invested money becomes insolvent, the credit agreement is still valid. So before you invest, you should definitely check with whom you have signed the credit agreement.

In the worst case in such a scenario it is the insolvent platform. But you still are partner of a loan, so it doesn’t really matter.

Management of 1,000 loans and more

In another article, I will discuss why it is important to diversify lending in P2P as well. Let’s assume here that you did exactly that and invested your money in many loans with a small contribution. Do you want to manage 100, 200, 500 or even creditcontracts? If one platform is bankrupt, you have to manage it all in your own risk (and time).

This is a lot of work. I don’t know how to react. Probably I do not want to manage them. Would you? So I would rather search for an agent or take the loss. In addition, a financial crisis first hits those whose financial situation is difficult. So the question is how many of your credit agreements will still be serviced and how many procedures you would have to start because of late payment.

P2P lending has risks that can be diversified

This section, however, was about assessing the risk of P2P lending. If you are sufficiently diversified on one platform and do not go all in for one loan, you share the risk well. In addition, accounts should be maintained on different platforms from different countries of origin so that regional risks can be diversified.

If you do this, the default risk will be significantly minimized. If a platform breaks down, you still have the option of managing the loans yourself – or handing the work over to someone else.

P2P lending or shares?

I can’t and won’t answer that question. Each of us has his own risk profile and should invest according to his own strategy. But if you compare P2P lending with a dividend aristocrat or a large global company, it is currently riskier to invest in P2P loans.

Why?

While a company can position itself globally, there is currently no P2P platform offering credit requests from all over the world. Usually a P2P platform focusses in local and regional loan markets. As the try to excpand, they usw neighbours. Therefore the risk is not globally diversified.

For Amazon, for example, the European business would collapse, but the American and Asian business would continue to perform well if there was a crisis in Europe. A European P2P platform would probably suffer much more from an EU crisis.

Comparing equities and P2P lending is difficult. If you limit yourself here only to the return, the stock market has an average return of 7% to 8% per year. Many credit offers in P2P lending bring higher returns. This leads to the reverse conclusion that P2P lending is somewhat riskier than a stock investment.

P2P lending together with other investments

The return on P2P loans has always been very attractive. In this respect, it is advisable not to evaluate the investment as “either or”, but to diversify the investments. I find a strategy that only relies on p2p lending dangerous. There the risk is not diversified broadly enough across the various asset classes.

I have decided that I want the p2p portion of my portfolio to be quite large, but not overweight. Especially the passive income plays an important role for me in p2p lending, which is why I will invest a share here. I am fully aware that this increases my risk. However, I am doing very well with this division.

At a young age, you can invest more risky money

You can use various formulas to calculate your optimal portfolio. A common formula says that the equity component is not greater than 100 minus age. The rest of the money should be invested in bonds that are much less volatile.

I am 38 years old and still have a good 25 years to retire. I would rather call myself “young” when it comes to the logic of the formula. That’s why I’d rather invest with a little more risk. My goal is to invest about 20% – 25% in p2p lending to increase the passive flow of income. Want to know more about me and my goals? Check here on my personal post!

P2p lending is risky, but as a yield kicker just the right thing for me.

I have brought you a little closer to p2p lending in this article. What is a p2p credit at all? How does it come about? And why are the interest rates so high?

I hope that you can answer all this question and that I could help you. What you do with the knowledge is up to you. In the next article I will report on my first investment in p2p credits.

My goal is to build as much passive income as possible. I will certainly not achieve my financial freedom through p2p lending. But the attractive interest rates will take care of my saved income and let my assets grow constantly. How fast it grows depends mainly on how much I will pay in monthly.

And now it’s up to you:

• How do you invest?
• Do you already have experience with p2p lending?
• What does your investment strategy look like?

I’m looking forward to your comments and to a lively exchange.