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P2P investing for beginners

If you've heard about P2P lending/investing but aren't sure how it works, you've come to the right place. I will explain all the basic things you need to know in this post.

The basic idea

Let's start with a simple overview. There are two main kinds of platforms - those where you directly fund a loan and those where the loan is already funded before you get a part of it. The first platforms 10 years ago all worked according to the first model. It means that the platform accepted applications from potential borrowers, performed credit scoring, and rejected the applications that didn't pass the test. If it decided to approve the application, it was then offered to investors who would fund the loan.

The second model was born in Latvia in 2015. There were a lot of non-bank lending companies at the time and they realized that funding their loans with money from private investors was more profitable than getting the money elsewhere so they created some P2P platforms. The main advantage of these platforms is that most of them offer a buy-back guarantee. What's a buy-back guarantee, you ask? Well, let's see.

The buy-back guarantee

On most platforms, if you are an investor, you assume the risk that the borrower won't pay. You get a higher rate - maybe 17-25% - but you know that some borrowers will definitely fail to pay so your return will be less than that. Some platforms offer a lot of data about the borrowers so you can analyze it all and try to pick the safest loans. Some platforms, on the other hand, offer barely more than a credit rating. Most platforms do have some kind of debt collection process, you don't have to concern yourself with that, but the effectiveness of this process varies with each platform.

Now, the buy-back guarantee is a promise that the platform or the loan originator makes to the investors - they will buy back the loan from the investor if the borrower's payment is late a certain number of days. Usually that's 60 days but can also be 30 or 90. The rate is lower - maybe 10-12% - but you don't have to worry about the borrower defaulting because you will get paid either way.

Risk

Of course, investing in P2P loans is not risk-free. On platforms without a buy-back guarantee, you have the risk that the borrower will default. In these cases, a lot depends on the platform's ability to vet potential borrowers and assign a correct credit rating. If the platform also has institutional investors, there's a chance that they get preferential treatment (meaning the best loans). On the other hand, having institutional investors is sort of a quality stamp for a platform - presumably institutions wouldn't invest there if it was unstable or fraudulent.

On platforms with a buy-back guarantee, the main risk is that the company offering the guarantee will become insolvent. This is sometimes hard to evaluate, but most platforms and loan originators do offer their financial reports precisely for this reason - to make investors trust them more. So far there's been one case of insolvency - a company called "Eurocent" on Mintos a year and a half ago. Supposedly Mintos has improved their risk assessment since then.

Auto-investing

One thing you have to take into account when investing into P2P loans is that you never know when your money might be paid back. The borrower might get money somewhere else and pay off the loan ahead of schedule. Or, the borrower might be a few days late with the payment every month. Or, the borrower might not pay at all and the platform might buy back the loan 60 days later. Or, the platform might perform debt collection and return your money a year later.

The point is - it would be very time consuming to log into the platform every day to check if you have free money in your account and to find good loans to invest in if you do. Some people enjoy this process but most don't want to bother with it. If a payment came in during the night, they want this money to be put into another loan automatically, and that's basically what auto-investing is.

Some platforms don't have an auto-investor because they loan huge sums to other companies and have maybe one new loan per week. In those cases, they will send out an e-mail when a loan becomes available and you will have to invest in it manually. But the platforms where the loan volume is higher usually do have auto-investors. In general it means that you can set up in what kind of loans you would like to invest (loan length, minimum rate etc.) and the platform will invest your money automatically if there are loans that fit your selected criteria.

I recommend choosing the first 5 or 10 loans manually, and when you have a good idea of how the platform works - set up an auto-investor.

Secondary market

Some platforms (most notably Mintos) have a secondary market where you can sell your loans to other investors. This is a good thing because it means that you can get access to your money anytime. For example, let's say you bought a 36 month loan but 6 months into the term your circumstances change and you want the money back. On some platforms, there's nothing you can do. Other platforms offer to buy back your loan but for a 5-20% fee. However, if there's a secondary market, you can usually sell any loan with a buy-back guarantee with a 1% discount. If the loan doesn't have a buy-back guarantee, the discount might need to be larger.

Diversification

Diversification means not putting all your eggs in one basket, and it's a very important principle in P2P lending. You should diversify among borrowers, loan originators and platforms. The more money you invest, the more important it is. Of course, if you start with a few hundred euros, you can put them all in the same platform. But as your investment portfolio grows, you should add more platforms to your list. (The exception, in my opinion, is Mintos because it has more than 50 loan originators among whom you can diversify.)

That's it for this post. If you want to try out this P2P thing, you can see the platforms I recommend on the right sidebar. Good luck!