Peer to peer lending loans are generally unsecured loans to people who don’t qualify for borrowing at lower rates due to having a higher risk of defaulting on the loan (not paying it back). As a result, they have no choice but to accept higher interest rates to make up for the higher risk.
The biggest problem with investing in high yield fixed income products like these are that many see the fixed, regular repayment and mentally align it with fixed-term deposits, which pays a fixed, regular payment and think it’s similar.
Those who think that higher returns from P2P lending come without increased risk are unwittingly playing a dangerous game. P2P lending is high up on the risk-reward spectrum. The higher return comes with higher risk (credit risk), and that risk tends to show up when the economy hits the skids, which is exactly when equities are falling, and they go down together. So, not only are they not safer than investing in stocks, but they also don’t offer the same diversification benefit as a safe asset class, such as government bonds do, which hold up much better during stock market and economic turbulence.
On their website, it says that RateSetter UK was founded in London in late 2009, and opened in Australia in 2014, so it has never been through a major financial crisis. As a result, it appears safe all the way back through the company’s inception, much the way if you looked at the stock market from late 2009 to today, it looks safe.
Asymmetric interest rate risk is another problem. When you purchase a loan, you have interest rate risk. If interest rates go up, you’re stuck getting the lower interest rate from the original loan agreement, which effectively lowers the value of your investment. However, unlike with other loans such as government bonds where the reverse is also true, and you get a benefit when interest rates go down, with P2P lending, borrowers can just borrow elsewhere at the new lower interest rate if rates go down and pay back your loan early. As a result of this early repayment option, you get no corresponding reward for the interest rate risk you’re taking. Taking on risk without a corresponding reward should raise red flags.
Concentration risk is another risk without a corresponding reward. If you’re not diversifying into at least a couple of hundred loans and preferably thousands, you face concentration risk of a large portion of your money being lost to any single investment. Think of the amount of work involved in maintaining hundreds of individual loans. Not only that, you don’t have the option to diversify through the other 22 developed countries to reduce single-country risk.
On top of this, these products are terribly tax-inefficient. Unlike shares where the company can retain earnings or use share buybacks to increase the shares’ value without you having to realise gains for potentially decades, the returns on these are 100% taxable. On top of that, there is a 50% discount on capital gains for shares held over 12 months, which you don’t get with these investments as the capital value depreciates instead of appreciates.
A risk level up there with stocks, without better returns, or the ability to diversify into thousands of investments across dozens of countries, poorer liquidity, uncompensated interest rate risk by way of prepayment risk, and being extremely tax-inefficient. I don’t see the attraction.