Investing in loans isn't as easy as it seems
At first glance, investing in loans seems easy and safe. They indeed look like an investor’s dream made true, promising a low risk combined to high returns.
Imagine… you invest € 1,000 for a year in a loan with 12% interest rate; after one year you get back € 1,120 – a € 120 net gain -. Shall the borrower ever stop repaying, the buyback guarantee will kick in, so the lending company will reimburse the remaining principal – and even the accrued interests -.
Unfortunately, there are two wrong assumptions in this scenario.
First comes the potentially most costly mistake : many investors have way too much faith in the buyback guarantee. In all honesty, I’ve been guilty of this. The presence of this so-called guarantee leads to a very strong and unfortunately often misleading sense of safety.
Here are two testimonials of investors with negative returns after investing in “guaranteed loans” from low-quality lending companies.
They may actually recover part of the invested funds, but the process will take years !
Moreover, the underlying loans mechanisms are often greatly misunderstood by beginner investors. It’s actually not trivial to compute returns when investing in a loan, and many factors will often make the actual returns lower than the interest rates.
For example, consider the following question, which got posted on the Mintos Telegram Discussion Group :
One may think that the answer is easy, but what about this other question, found on Moncera’s group ?
Finally, even when investors have realistic returns expectations, their actual returns may turn out to be lower. Indeed, the fine print in many contracts will allow lending companies to play somehow dirty tricks, which will reduce the final returns.
All these misconceptions made me realize that a P2P guide for absolute beginners was greatly needed. The result is a complete rewrite of our previous documentation.
P2P (peer-to-peer) loans
In the case of peer-to peer loans, the borrower is an individual. He may need funds to buy a new car, renovate his house or simply because he has temporarily run out of money.
Regardless of the borrowed sum – which can vary greatly from one loan to another -, it’s usually possible to start investing as little as €10. Indeed, loans are usually split between many investors. The loan durations can range from one month or less for payday loans to several years for car loans. One noteworthy point is that interests are repaid monthly, which allows for a regular cash-flow.
A key concept is that the borrower and the investors aren’t in direct contact. Instead, the funds are actually lent by a financial firm – called loan originator or sometimes lending company -. For many loan originators, the loan will then be available to investors through a loan marketplace such as Mintos or PeerBerry.
Loan marketplaces often feature many loan originators, which can complicate the investing process. However, several lending companies have their own platform for P2P loans; it’s the case of Robocash or ViaInvest for example. In this case, the risks of the investment are much more easily evaluated.
Skin in the game
Each loan is usually split between several investors. In addition, loan originators on most marketplaces have to finance a small percent (usually 5% or 10%) of the loan using their own funds. This amount is called Skin in the game, and is supposed to encourage them to provide quality loans.
Here’s a pie chart showing a car loan on Mintos. The loan originator’s skin in the game is 10%. Only 3% of the loan has been invested in by 19 different investors; the remaining 87% are still available for other investors.
Most P2P loans come with a buyback guarantee, which I already briefly mentioned. According to this so-called guarantee, if the borrower stops reimbursing the loan, the loan originator has to buy back the loan from the investor after a given delay – usually 30 or 60 days -. Whatever principal is left to be reimbursed will be transferred back to the investor. In most cases, this guarantee also covers the accrued and unpaid interests.
Thus, in theory, although there may be a delay, the investor will receive the expected interests – whether from the borrower or from the loan originator -. We’ll shortly see that in practice, the reality often didn’t match the theory.
In order to acknowledge the fact that the buyback guarantee can’t always be enforced, several peer-to-peer platforms now call it Buyback obligation.
Indeed, as I will demonstrate in the section about investing risks, investing in P2P loans actually means entrusting the lending company with your money – not the borrower -. Unfortunately, some of them are small firms with very few employees and a long history of financial losses. On the other hand, several are international groups with consistently profitable results. In consequence, it’s vital to be able to distinguish between them and choose reliable loan originators.
Another kind of loan is real-estate loans. In this case, the borrower is a company which will use the money for development or renovation of real-estate properties.
The borrowed amounts are much larger than for individual loans, often a few hundred thousand euros. As a consequence, the entry ticket for investors is also higher : the minimal invested amount is usually €50, sometimes even €100.
In terms of durations, real-estate loans commonly last longer than individual loans – usually from one to two years -.
Another difference with P2P loans is that real-estate loans don’t always yield interests monthly. Indeed, in many cases, the borrower can only repay once the project is completed and sold.
It’s thus very important to check the repayment schedule if you’re looking for regular repayments. In this case, you should especially avoid “Full bullet” loans, where both capital and interests are reimbursed at maturity date.
Here’s an example of a loan description with quarterly repayments :
Unlike peer-to-peer loans, there’s no buyback guarantee for of real-estate loans. However, the borrower has to offer a collateral in order to guarantee the loan. It will be resold in case the borrower can’t repay the loan; if its value is sufficiently high, the recovered amount will be enough to reimburse the principal – and, if done properly, even the interests -.
P2B (peer-to-business) loans
Investing in business loans is tempting. Indeed, interest rates are usually very high, as exemplified by the following loan at Crowdestor
However, I can only advise beginner investors to stay away from this kind of loans. Indeed, unlike real-estate loans, the reliability of the guarantees provided by the borrowers is often hard to evaluate. In addition, delayed repayments are commonplace.
One exception may be agriculture and crop finance. This asset class is gaining a lot of traction in 2021, as both HeavyFinance and LendSecured offering this kind of loans. The value of the collateral – land or agricultural equipment – can be appraised precisely, and the risks are easier to evaluate
Basic math for P2P loans
I apologize in advance if this section may seem too math-heavy. However, I think it’s essential to explain how loans are usually reimbursed, as it obviously has a direct impact on how investors will receive interests !
The first thing to know is that loans interest rates are always expressed on an annual basis, regardless of the loan duration. It makes them much easier to compare.
So, going back to the question in the introduction, the answer is clear : if you invest € 100 in a loan with a 16.5% interest rate for 28 days, there’s now way you’ll end up with € 116.5.
However, in a counter-intuitive way, if you invest the same amount in a loan with the same interest rate but with a one year duration, you won’t get this amount either – unless it’s a “full bullet” loan, where both principal and interests are repaid in a large chunk at the maturity date.
In order to understand why, we need to understand how loans are reimbursed. We’ll focus here on amortized loans, which are the most common ones for peer-to-peer lending. For these loans, both principal and interests are repaid each month.
Interests computation for amortized loans
A key point is that the interests are readjusted monthly, in order to account for the reimbursed principal; they will thus decrease month after month.
As a reminder, you will never have to perform the following computation by hand; all platforms provide a reimbursement schedule. However, seeing these equations in action once will help you understand how things really work.
Let’s illustrate it with the following loan. The total borrowed amount is € 2,000 at 14% interest rate, for a duration of roughly one year. The first repayment is expected one month after the beginning of the loan, on February 18th.
In general, the formula used to compute the monthly interests is the following :
On February 18th, the repaid interests are thus : 2000*(14/100)*(1/12) = € 23.33.
The remaining installments are computed the same way. We can double-check the result of these this computation on the following schedule.
Importance of reinvesting the reimbursed capital
Let’s now consider the sum of all interests payments : it’s € 167.31. However, 14% of €2000 is €280. Where did the remaining interests vanish ?
The answer is simple : as an investor, you’ll only get interests on invested money. However, on February 18th, the borrower reimbursed not only the interests, but also part of the capital (€ 119.72). Thus, the next interests reimbursement is computed based on a remaining capital of € 1880.28 instead of € 2000, as he reimbursed. Other reimbursements follow the same pattern, and are thus based on a decreasing remaining capital.
As a result, in order to actually receive €280 in total (thus achieving a 14% return), you need to reinvest all reimbursed principal as soon as it reaches your account. This means reinvesting the part capital (€ 118.72) reimbursed on February 18th.
As we’ll see, this reinvestment is usually carried out automatically using the platforms’ auto-invest feature.
One quick word about returns
Returns are usually expressed for the whole duration of the investment, either in percentage or as an amount. However, it’s usually hard to compare the expected returns for two different investments, because their durations may not match.
Moreover, as we’ve just seen, the only way for annualized returns to match the interest rates is to always have 100% of the portfolio invested. However, this is seldom the case. In most cases, your actual portfolio’s performance will be lower than the interest rates.
Several reasons explain this fact :
- It’s not always possible to reinvest immediately : all platforms have a minimum investment amount, so you won’t be able to reinvest until the accumulated reimbursements reach this threshold
- In addition, the may be a loans shortage, or the loans characteristics may have changed, which will prevent a restrictive auto-invest from investing
- If the borrower of a P2P loan doesn’t repay, it takes time for the buyback guarantee to trigger. Until it does, the returns will mechanically decrease.
When investing in loans, one obvious risk is that the borrower may be unable to repay the loan. Here’s how to evaluate and mitigate this risk.
Reliability of P2P loans' buyback guarantee
The key point to consider when investing in loans covered by a buyback guarantee is that this “guarantee” is only as solid as the loan originator. If the loan originator runs into financial troubles, it may end up being unable to reimburse the investors. This is usually the start of a long judiciary process. It’s likely to take years, and in many cases will result in the loss of at least part of the invested principal.
It’s thus – once again – very important to invest in loans issued by solid lending companies. Don’t let the high interest rates and presence of a buyback guarantee blind you, you’ll end up getting burned !
Marketplaces such as Mintos provide a rating for their originators. However, as pointed out in our article about Mintos originators, they’re often unreliable and should be complemented by independent ratings from ExploreP2P.
LTV (Loan To Value) ratio for real-estate loans
These loans are usually secured by a collateral – which may be either a property or land -. The value of this collateral can usually be appraised rather precisely; based on it, it’s possible to compute what’s called Loan To Value ratio – LTV in short -.
The formula is very simple : it’s simply the value of the collateral divided by the loan amount, expressed as a percentage.
For example, the funded amount for the following project at *BulkEstate is €137,500, while the collateral’s valuation is €250,000. As a result, the LTV is 137500/250000*100=55%.
Smaller values usually make safer loans, as the value of the guarantee far exceeds the principal amount.
It’s possible to find very safe projects with an LTV as low as 30%; however, most projects will have an LTV around 60% or 70%. This is usually enough to recover the invested principal in case the borrower defaults, sometimes along with the accrued interests and penalties.
Loan originator risk
Allow me to reiterate : you risk losing most of your investment when investing in low-quality loan originators. If defaulted originators used to be a rarity, 2020 saw many of them. Once again, I encourage your to read out detailed article regarding Mintos loans originators.
In addition, even reliable loan originators can play dirty tricks which will result in decreased returns for investors.
The fine print : late repayments and extended loans
Most peer-to-peer loan marketplaces grant their loan originators a lot of leeway when it comes to managing their loans.
Consequences can be benign, for example the lack of interests when a borrower is just a few days late in her/his repayments. However, in the worst case, it may also cause the invested capital to be stuck for much longer than expected.
Three points in particular should be taken into account.
First, nearly all originators have a “grace period”, where delayed repayments don’t incur any penalty. This consequences of this visible are mostly visible for short-term loans, where even a small delay can have great consequences on the returns
In addition, the borrower can often extend a delayed loan. In this case, the originator doesn’t have to buy it back. The expected duration of a loan can thus be greatly increased by this mechanism. Although it won’t have consequences on the final returns, it will result in the invested funds being locked for much longer than expected.
Finally, loan agreements usually contain a clause which allows the loan originator to buy back the loan. This usually happens if interest rates are down over some period of time. In this case, the originator will buy the loans whose interest rates are way above the new market normal, and simply put them back on sale on the marketplace with a lower interest rate. This will result in reduced returns compared to the initial investor’s expectations, as he will probably have to invest his newly available capital in loans with lower interest rates !
Once the borrower makes a repayment to the loan originator, the funds are transferred to the investor’s account. This operation is usually very fast; however, if a low-quality originator runs into financial troubles, it may very well withhold the funds for a very long period without much consequence !
As an illustration, funds from Viventor’s loan originator Monify have been “in transit” for a whole year !
Investing only in P2P loans secured by a buyback guarantee from a reliable loan originator or real-estate loans with a low LTV is a necessary step in order to protect your capital, should the borrower default.
However, other risks – which are often under-estimated – exist. Indeed, most P2P platforms are startups which can be poorly managed at best, or at worst prove to be scams. It’s thus vital to do at least some basic due diligence on the platform’s track record before investing.
The lack of regulation of the crowdlending sector has resulted in a rather appalling track record for Baltic platforms :
- At least three P2B loans marketplaces (Envestio, Kuetzal and Monethera) proved to be scams -.
- Investors are suing peer-to-peer marketplace Grupeer after it stopped repayments in Spring 2020. Several loan originators on the platform seemed to be fake, as well as several real-estate projects.
- In addition, several alleged scams are still in activity. Among them, TFGcrowd, Fast Invest, Quanloop and Iban Wallet.
Poorly managed platforms are another risk. Before investing your funds, it’s crucial to have a look at the platform’s public statistics. Their absence should be a clear red flag !
For example, EstateGuru publicly displays the status of the loans portfolio. Here’s what it looks like :
As we can see, the number of defaulted or late loans stands at a very reasonable level.
On the other hand, roughly half of Crowdestor’s portfolio is delayed :
Funded volume trend
The funded volume also often gives a good indication of the platform’s health. Here’s the chart for funded volume at P2P marketplace PeerBerry :
As expected, the regular growth of the investments was stopped when Covid-19 hit. However, it has since resumed its uptrend, which shows a large degree of confidence towards this marketplace. Again, contrast it with Viventor’s same statistics :
The funded amount nearly hasn’t increased in the last year. Indeed, most investors now distrust this marketplace, as many loan originators on the platform are in a very bad financial situation.
Investing in either peer-to-peer or real-estate loans is usually a five-steps process.
Opening an account and verifying your identity
First, you need to create an account with the platform. You’ll usually need to provide only basic information about yourself : name, date of birth, address.
Most platforms now have a KYC (Know Your Customer) process, which will usually require you to take a picture of some identification (passport or national ID card), along with a selfie of yourself holding this document.
KYC checks are usually trivial for platforms using Veriff; other solutions may be much less user-friendly and require several submissions before being validated.
Funding your account
Next step is to deposit funds. All websites allow you to do this through a SEPA transfer; other options may be available as well.
If you use an online bank it’s really a matter of seconds : just copy-paste the bank information provided by the website. They usually provide many details, but you’ll probably only need the bank name and IBAN (International Bank Account Number).
You may want to save them for later use, in the likely case you want to deposit more funds ! Just be careful to use the right instructions for the transfer (called “Reference text”, “Payment Details” or “Payment purpose”), as they allow the platform to sort out the funds deposited by the different clients.
The funds will usually be available for investing after 2-3 days – or even within one hour when using instant transfers ! -.
Some platforms allow credit-card deposit but it’s not very common, and I would basically advise against it as it will reduce your credit card’s monthly limits.
Investing in loans
Once the funds are available for investing, it’s finally time to invest ! You can usually choose between manual and automatic investing. Both modes allow you to specify which loans criteria to apply. The most common ones are :
- interest rate
- loan duration
For P2P loans, it’s also crucial to specify the loan originators. On the other hand, real-estate loans are usually filtered by LTV level.
When investing manually, filters allow you to display only the matching loans. You’ll then be able to select the ones you want to invest in. Here’s an example of the filter and resulting loans for individual loans:
For real-estate and business loans, the process is much simpler. The number of loans is much smaller than for P2P lending platforms, so they’re usually all displayed without need for filtering.
This screen is usually much more appealing visually than for peer-to-peer loans !
It’s also possible to invest automatically by configuring the investing criteria you want to use, in a way similar to the filtering used when investing manually in individual loans. You’ll also set the maximum loan size and your desired portfolio size; other options will usually control whether the interests get reinvested or not.
Once started, the auto-invest will automatically invest your available funds according to your preferences, provided there are matching loans available.
Watching your account grow
As the principal and interests are reimbursed by the borrowers, your account will grow. If you’re using auto-invest and chose to reinvest the profits, the system will automatically invest in new loans.
All platforms provide statistics on your account, which help you keep track of your investments and portfolio’s growth.
As a safety measure, the withdrawn funds are always sent back to the original account they were transferred from.
Note that withdrawing funds will often require you to pause the auto-invest ahead of time, in order to have funds available.
Many platforms also provide a secondary market. This feature allows investors to resell their loans before their maturity date to other investors – or sometimes directly to the platform -. It’s a way to get out of a loan prematurely, should the need arise.
Not all platforms offer this feature, however. Moreover, it may incur a fee – at most 2% -. Worse, in case the loan has to be bought by other investors, you may have to sell it with a discount. Selling the loan may also take some time, as there may not immediately be a buyer.
Diversification the right way
I was always well aware that putting all my (financial) eggs in the same basket is bad. As a result, I tried to diversify my loans portfolio; unfortunately, I did it the wrong way. Indeed, my naivety led me to invest in several crappy platforms, which turned out to be scams. After losing money on many P2P scams, my overall annual returns are barely positive – around 3% -.
Lesson learned. When it comes to diversification, I became an adept of “less is more”. I pick up only reliable loan originators and I’m slowly reallocating my money to focus on the most trustworthy platforms. As a result, although Mintos counts more than fifty active loan originators, I only invest through three of them on this marketplace – plus two outside of Mintos -.
Don’t make the same mistakes as me. Investing in many different platforms or through a large number of originators will increase the risk instead of reducing it !
Even with a large portfolio, using one or two different platforms for real-estate loans and less than ten loan originators will result in a well-diversified portfolio.
Recommended platforms for beginners
This selection of platforms is intentionally kept very short. Indeed, it only includes widely trusted platforms.
For real-estate loans, choosing EstateGuru is a no-brainer. It’s the highest rated platform on Alternative Investments, and I recommend it for all investors without reservations.
The first strength of EstateGuru is its excellent recovery process. Indeed, only one project resulted in a capital loss for investors until now – a truly outstanding result, given that more than two thousand loans were funded through the platform ! -. In addition, the return rate for defaulted loans currently stands slightly below 10%, which is only slightly lower than the returns for repaid loans.
There are two main reasons for this excellent track record. First, the LTV for most projects stands at a more than reasonable level. Second, EstateGuru doesn’t rush to enforce the recovery. Instead, they give the borrowers some time to repay the loan or sell collateral themselves. As a result, although the process is lengthy – around 8 or 9 months on average -, the recovered amount is optimal.
Another big positive of EstateGuru is their high level of transparency. For example, very detailed projects descriptions are provided, including the collateral valuation. The platform also provides a monthly overview of their overall loans portfolio, including “problematic” (late or defaulted) loans.
The availability of a secondary market may be helpful to investors who need to resell their loans. This will incur a 2% fee, however.
On the minus side, the auto-invest is limited unless one invests at least € 250 per project. For many of us, that’s a lot of money… especially when trying to build a diversified portfolio by investing in several projects. As a result, many investors will have to spend a little time to pick up loans manually. In addition, not all projects follow a monthly repayment schedule.
It’s also worth noting that the interests computation doesn’t start on the day you invest, or even once the project is totally funded. Indeed, the platform has a lot of paperwork to fill before the loan is actually concluded with the borrower; it may take up to four weeks. This will result in returns which are lower than the interest rates on the platform.
Interest rates at EstateGuru stand around 10%. In terms of actual returns, the performance of my portfolio is around 8%. It’s currently lower than expected, as many loans on my portfolio are “full bullet” – that is, the principal and interests will only be repaid at maturity date.
Moncera is a relatively recent platform – it went live slightly more than one year ago -. However, it’s backed by Placet Group, a highly regarded financial group which provides loans in Estonia and Lithuania. As of January 2021, Placet group is rated 79 out of 100 by ExploreP2P, which provides independent ratings for loan originators.
Loans on the platform are medium to long-term, with durations ranging from a few months to eight years. Interest rates tend to fluctuate but usually range from 8% to 11%. In my case, as of April 2021, actual returns are slightly above 10%.
Because of its dated and poorly translated website, Robocash isn’t for absolute beginners. It’s a pity that this platform is handicapped by its poor interface; fortunately, a redesign website is planned to be unveiled in the coming months.
The platform’s reliability is on par with Moncera’s. Indeed, it’s been consistently profitable for many years, as proven by audited financial reports. ExplorerP2P rate it 78, which is just one point below Moncera.
One difference with Moncera is that Robocash and the platform’s loan originators are actually owned by the same group (Robocash Group). On the contrary, Moncera was founded by two ex-employees of Placet Group, but is a distinct entity.
Robocash’s loans are usually shorter – there are often payday loans with only one month duration -. Interest rates currently stand around 11%, and vary depending on the loan duration. They used to be 14% in early 2020 before decreasing in Autumn. In terms of portfolio performance, after several years at Robocash, my annualized return is slightly below 13%, which is an excellent result.