A quick introduction to borrower’s default
The greatest risk when investing in loans is a default from the borrower, that is he/she stops repaying the interests and principal.
What happens to your investment in this case depends on the loan characteristics; many offer what is called a buyback guarantee. It means that the loan originator will reimburse the principal (and often even the interests) after a delay, commonly two months. We’ll cover this important mechanism in a later chapter.
However, not all loans come with this guarantee. It usually only covers individual loans, as platforms for business and real-estate loans don’t offer this feature. In this case, you’re likely to suffer a loss in case the borrower defaults. Possible outcomes of a borrower’s default are examined in great detail on a specific article.
For individual loans, in order to evaluate how risky a loan is, the platform will usually assign it a rating. If the borrower has a low credit rating, the default risk is higher, but the loan will usually yield higher interest rates.
Here’s a loans list showing the assigned risk rating for each loan at Iuvo :
It’s also a great idea to look at the platform statistics to help you in your decision, as the rating themselves are rather subjective. The default rate itself for each rating is much more meaningful.
Other platforms may rate the loan originator itself rather than the borrower. Here are these ratings at Mintos :
The first column is the overall risk score for the loan originator; it’s based on the detailed ratings provided on the four next columns.
You may wonder what’s the meaning of the SW score which apprears for several loan originators. It means Score Withdrawn, and is given to companies which aren’t part of Mintos anymore. Indeed, the “D” letter stands for “Defaulted”, and the “S” for “Suspended” – the step before being defaulted -.
It’s this crucial to pay attention to this rating! Indeed, if the loan originator becomes financially distressed, it’s unlikely that it will default and won’t be able to cover the buyback guarantee. In this case, investors will probably lose at least part of the invested capital.
Risk for other kinds of loans are trickier to evaluate, so they’re more suited for intermediate and advanced investors. A few platforms provide their own evaluation of the project’s risk, as shown in this screenshot where the project is assigned a rating between A1 (least risky) to C5 (most risky).
Platform’s track record
Also, when investing in real-estate or business loans, it’s critical to look at the platform’s track record and check how many loans are late or defaulted. If defaults happened, prospective investors need to assess how well it was handled by the platform.
For example, the following graph, taken from a real-estate loans marketplace shows than even if 3% of loans defaulted, this didn’t incur any capital loss for investors. Indeed, the value of the collateral provided by the borrower was large enough to cover the loan’s amount, so the investors could be reimbursed – in this case they received not only their principal back, but also the accrued interest ! –
On the other hand,
After this easy introduction to investing in loans, our next article will help you determine your investor’s profile; that is, deciding which loans to invest in.
Please note that Alternative Investments also features an article where consequences of a borrower’s default are covered in great details, It may be a worthwhile read later !