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What are the risks of investing in p2p lending for passive income?
P2p lenders need to be aware of the risks their capital is exposed to. If the goal of the of a p2p lending investment is to become financially independent, it is even more important to learn what are the risks of this asset class and how to mitigate them.
Risks to passive income when investing in p2p loans
1. Recession: Peer to peer lending has been relatively successful so far, however, this asset class has not yet experienced a significant economic crush similar to 2018. A recession is bound to happen at some point because the economy works n cycles. This sense of tranquillity could lull investors into a false sense of security. P2p lenders could be under the false assumption that their p2p loans are their savings. This is not the case, p2p loans are investments and investments carry far more risk than savings.
2. No Capital Gains: For the passive income investor there is always a trade-off between capital growth vs passive income. Peer to peer loans unlike dividend stocks has limited upside potential. The amount lent can never increase while the capital invested in a stock can.
3. Lock in: Peer to peer loans have a lock-in period for the lender, this could range from a few months to a few years. Went lent the capital is no longer accessible. If a better passive income investment opportunity comes along it the investor will not be able to profit it from it. Investors can sell their investment early, if a secondary market is present. Some platforms have minimum investments, some as high as 5,000 Sterling. This locks in quite a substantial amount of capital for periods of six months or more. If such loans are not paid in full, the small investor can end up with idle capital on the platform which cannot reinvest because they do not have the minimum to invest
4. Too much choice: Today there is a lot of choice of p2p markets and p2p platforms for lenders; this could lead the investor being overwhelmed when choosing which platform to choose from.
5. Currency risks: Inflation. Inflation is a risk because it reduces the purchasing power of capital. When passive income assets are not linked to inflation, this risk is higher. TIPS is a passive income asset which has some inflation protection. Rental property and dividend portfolio also offer some protection against inflation. p2p loans can be negatively affected by inflation because the returns on loans are fixed. Investing in p2p loans in different currencies exposes the investor to currency-related risks.
Not all currencies are as stable as the Euro and the Dollar. See the example: Sterling and the Turkish lira. Currency crisis include new spending initiatives by the government, devaluation, capital controls, competing for private currencies or even currency wars; all of which do not have a positive impact on the p2p lender. Also moving, funds from one currency to another is expensive in both exchange fees and maintaining accounts in the two currencies.
p2p platform related risks
6. Not understanding how the p2p platform works, secondly not understanding what are the specific loan types and third what are the risks in those loans. LTV (loan to value ratios) is the value between the lent amount and loan collateral. This acts as a guarantee that protects investors from the risk of default. If the borrower fails to pay them, the collateral is sold to pay back the lenders. The LTV ratio can change because of incorrect initial asset valuations provided by surveyors or changing market conditions.Loans come in different types bullet loans, amortized loans and non-amortizing loans.
Not understanding these terms creates a risk. The differences in these types of loan are essentially when the capital is paid back. Bullet loans, , are not suitable for passive income because they are paid back in one go and do not offer that stream of income.
7. Incorrect auto investor settings. The auto investor is an automated system which automatically invests the idle capital in peer to peer loans. There is one aspect which makes this passive income investment even more passive. The danger is that incorrect settings in the Auto investor, will result in the wrong loans being bought.
8. Pre Set Auto investors settings. Investors always need to do their own research. Platforms have a vested interest in selling loans. They are biased more towards their own agenda rather than that of the investor.
9. Cash Drag is when money is idle in an account not earning any passive income. This occurs when the supply of loans does not match the demand.
10. Regulatory and taxation Risks: Regulation in this sector is still evolving, some platforms ask for detailed KYC/AML and even tax certificates. Some platforms tax at source others leave it to the investor. This adds an overhead of understanding and providing all the information. Investing in other countries other than the tax domicile may decide in of double taxation. Accountants and tax lawyers can deal with these issues easily, but they tend to be expensive.
11. p2p platform management. Humans can make mistakes or wrong decisions about loan sourcing, hiring, LTV ratios, policies or expansion. All these are a risk to the p2p investor which can negatively impact his cash flow of passive income,
12. Transparency: Some platforms are much more open and transparent than others about their liquidity and ability to honour their guarantees if they offer any. The buyback guarantees are backed up by reserves. The reserve amounts change. It is crucial for investors to understand the ratios between the reserves and the guarantees. Peer to peer platforms located in jurisdictions which have a strong rule of law, fraud detection and financial investigative services are less of a risk. The investor can more eaisly pursue platform located in these safer jurisdictions in case of trouble.
However, this may not be the case for platforms where the rule of law is not as strong. The reserve ratio depends on the amount of funds left after operations and dividends are paid to the shareholders. I believe there should be more regulatory scrutiny on this aspect of p2p lending; in my opinion, the fall of any buyback guarantee is the biggest risk to the passive income investor.
13. Fraud: Any investment platform has a fraud risk such as money laundering. Regualtors can temporarily shut down the p2p plaftform. In this case the p2p lenders will not have access to their funds until the regulators re-open.
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Peer to peer lending is a valuable asset class for the passive income investor, it has many strong advantages when used in the right way. Our article, on how to invest in peer to peer lending will help teach you how to effectively mitigate these risks.