I have to admit that Peer-to-Peer lending was not at all on my radar until recently. Only when I saw that Harmoney was granted FSA approval back in July did I start to research the emerging topic. This article is written from the point of view as an investor, not a borrower, so I will not cover issues regarding taking out a loan from a P2P platform.
First, the basics.
Definition of ‘Peer-To-Peer Lending (P2P)’
A method of debt financing that enables individuals to borrow and lend money – without the use of an official financial institution as an intermediary. Peer-to-peer lending removes the middleman from the process, but it also involves more time, effort and risk than the general brick-and-mortar lending scenarios. Also known as “social lending”. 1
P2P lending sites or platforms act as loan originators and servicers, but it is the investor/lender that actually takes on the risk. P2P platforms do the credit checks and assign a risk grade to a loan application. If approved, the loan is then placed on the platform’s marketplace for investors to decide whether and by how much to fund the loan. Once fully funded, the loan funds are disbursed. Later, each month, the platform collects payments made up of principal and interest, deducts a fee, and distributes payment to investors’ accounts. Should accounts fall into arrears, the platform handles collection procedures to recover payments.
It is up to investors to decide which loans to fund and by how much. Loans are fractionalised into small “notes” and investors are encouraged to spread their risk by funding many loans rather than concentrating their investment in just a few.
Leaders in the P2P lending market in the USA are Lending Club and Prosper. Because Harmoney is a new platform and there is not yet performance data available, I think it is worth studying the experience over at Lending Club before jumping in. There is a lot of information at their site which I found helpful in forming my strategy for investing at Harmoney.
Leading the way — P2P lending in New Zealand
As already mentioned, Harmoney is the first P2P lender in NZ to receive a license to operate. Harmoney has done well in raising early funding both through equity investment in the company and through wholesale investment through the platform, mainly from Heartland Bank, Blue Elephant Capital Management, and TradeMe.
Harmoney makes its money in two ways. First, by charging the borrower an origination fee based on the size and risk of the loan. Also, “Investors are charged a Service Fee of 1.25% of the principal and interest payments collected on each note. The service fee is deducted from repayments into the investor account. The fee is paid to Harmoney for managing borrower repayments and administering the account on behalf of investors.”2 The other cost for investors is when Harmoney takes legal action against a borrower, those legal costs “may be recovered before remitting the balance of payments to the relevant investor accounts.”3
The loans offered on Harmoney are for either 36 or 60 months and a single note is for $25 lent. Borrowers may repay early with no penalty. Borrowers pay interest rates between 9.99% and 39.99% per annum. Payments are made and distributed to investors monthly. There is currently no way to sell notes to cash in an investment early, so investors may have to wait the full 36 or 60 months to get their entire principal back. Unlike a bond or term deposit, the interim cash flows are higher because regular payments are made up of interest and principal.
The primary risk inherent in peer to peer lending is that investors may not receive all of their monthly principal and interest payments due to loan defaults 4.
Sources of risk in P2P lending are likely to be fraudulent loan applications which could lead to loans made to identity thieves, or to those without the ability to repay, or the assignment of a risk grade that doesn’t accurately reflect a borrower’s risk. Harmoney has measures in place to prevent these from happening but only time will tell whether these are effective. I look forward to Harmoney publishing loan performance data in the future.
The primary method for an investor to minimise the risks are to take full advantage of fractionalisation and spread their investment over many loans. They can also limit investments to certain risk grades. I’ll be writing more on this topic soon.
A new asset class
I think P2P lending is exciting because it’s a new asset class that individual investors have not had access to before. New internet technology and fractionalisation of loans allow individual investors to hold diversified portfolios of consumer credit loans that before were only available to financial institutions. I think it is a certainty that P2P consumer debt will be exposed to economic cycles and it will underperform during a downturn. The same can be said about certain sectors of the sharemarket. It remains to be seen whether the interest earned in good years will be enough to compensate for potential losses in bad years.
I don’t think that P2P lending should substitute for high quality bonds in a portfolio. I would place it in a similar risk category with shares. There is definitely room for them as long as you have enough to invest to be well diversified. Right now, I won’t be rushing to invest large sums, and I will not be investing more than about 2-5 % of my portfolio in P2P loans.
- “Peer-to-peer lending” from Consumer.org.nz
- Lending Club Education Center
- “How it works” from harmoney.com
- “Elizabeth Kerr openly experiments with peer to peer lending using Harmoney” from interest.co.nz