What is peer to peer lending and how does it work?
Peer to peer lending involves borrowers taking out an unsecured loan with investors though the peer to peer lending platform, rather than borrowing from a bank or financial institution. On 11 May 2015, LendMe announced it was the first peer to peer lender in New Zealand to specialise in secured lending; offering offering a range of loan products secured by mortgage over borrowers’ assets.
If a borrower has a shining credit rating, borrowers can actually get competitive rates. The concept is really an extension of a very basic loan strategy – loaning money to a friend or family member is an example of a small form of peer-to-peer lending. An entirely new lending industry has stemmed from this basic concept; matching people who need money with other people who are prepared to provide the loans via an intermediary peer to peer lending service. It is generally up to the peer to peer lending service provider to sort out the administration, managing repayments and interest repayments and chasing defaults. Make sure you study up on how much the service provider is going to take care of.
Peer to peer lending kicked off in New Zealand in 2014, with the introduction of the Financial Markets Conduct Act 2013 (FMC Act). However, the form of lending is not new – it has been operating in the US and UK for over a decade. If borrowing from a big bank is unappealing, and you need an unsecured loan, it may be worth considering peer to peer lending. However, just be aware they generally only offer small loans and both borrowers and investors pay a platform fee to use the service.
Rules of peer to peer lending for borrowers
The Financial Markets Authority (FMA) sets out a number of rules for borrowers under the peer to peer lending business model:
- Be honest about the information they provide: how they will use the money and their ability to pay it back.
- They can borrow a maximum of $2 million in a 12-month period. Some services may allow only smaller loans.
Rules of peer to peer lending for lenders
FMA regulates peer to peer lending under the Financial Markets Conduct Act 2013. Under the regulations, peer to peer lending platforms must:
- Be licensed to provide services
- Only provide a platform for loans for personal, charitable, or small business purposes
- Comply with the Fair Dealing obligations in the FMC Act
- Have a written client agreement with lenders
- Give disclosure statements to retail lenders
- Meet reporting obligations
Untangling the web of peer to peer lending
While peer to peer lending can operate in various ways, it is generally carried out via a website. Borrowers list their request on the peer to peer lending website and then the investor selects which loan they would like to invest in. The level of detail about the loan varies. Sometimes websites show specifics, such as the reason for the loan and how much interest they will pay. Lenders can then either lend the whole loan amount, or a portion. Or, the website may group up similar loan types, so investors are able to invest in multiple loans at once.
Financial risk management with peer to peer lending
Investing is a risky business and peer to peer lending requires some financial risk management – mostly for investors.
Financial risk management for borrowers
There aren’t any huge risks for borrowers in peer to peer lending. There are generally more borrowers than there are lenders so, if a borrower’s application is approved; they are likely to find an investor for their loan.
Financial risk management for lenders
On the borrower’s side, it’s great news if you’re in a position to pay back a loan earlier. But, if you’re the lender, a loan paid back early means missing out on earning more interest from the loan. Even worse, if a borrower defaults on the loan, then the investor risks capital loss. Although, investors are rewarded for taking on that risk; the returns for investors are, in general, better than the interest they would receive from investing money in a term deposit or savings account.
Risks for investors
There are some risks for investors, such as borrowers repaying their loans before the investor earns much interest – or the risk of capital loss if borrowers default on a loan. For that increased risk though, the returns for investors in general are better than the interest they would receive from investing their money in a bank term deposit or savings account. On their one-year anniversary, Harmoney reported they had seen a consistent default rate of just 4.5%. Investors “fractionalise” their investment by apportioning their chosen number of $25 units into different loans, so that their eggs don’t end up in one basket.
Your options for peer to peer lending
The FMA has licensed five peer-to-peer lenders at the time of writing, which you can find on their online register: https://fma.govt.nz/compliance/lists-and-registers/licensed-peer-to-peer-lending-services/
- Harmoney (NZ’s first P2P lender, launched here in September 2014)
- Squirrel Money
- Lending Crowd
More information on peer to peer lending is available on the FMA website.