Evaluating the risk of investing in loans

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.

Buyback guarantee

What happens to your investment in this case depends on the loan characteristics; many offer what is called a buyback guarantee. It means that you will be reimbursed the principal (and sometimes even the interests) after a delay. We’ll cover this important mechanism in a later chapter.

However, not all loans come with this guarantee. It usually covers individual loans, but many large platforms for business and real-estate loans don’t offer this feature yet. In this case, you’re likely to suffer a loss in case the borrower defaults.

Platform’s rating

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.

Example of borrower rating
Example of borrower rating

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.

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).

Example of rating for business or real-estate loan

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 ! –

Loans status on EstateGuru
Loans status on EstateGuru

Digging further

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 !