Peer-to-Peer Lending: Kick-Starting the Future of FinanceSep 23, 2014 Blog Personal Finance
Peer-to-peer lending, also called social lending or P2P lending, has recently arrived in South Africa. But what is it, and is it a good thing? In this article we will take a look at what P2P lending is and how well it is doing overseas, before looking into the positives and negatives of social lending.
What is Peer-to-Peer Lending?
Peer-to-peer lending enables people to lend money to other people without the need for a bank. A lender may lend to one person, a portion of what they are asking for, or the full amount. Alternatively a lender could lend a small amount to a number of borrowers and a borrower could obtain the amount required from several lenders.
Peer-to-peer lending platforms such as RainFin allow this process to be seamless and transparent. In addition the platform can offer other services such as credit checks on borrowers, debt collection, interest rate negotiation etc.
Peer-to-Peer Lending Around the World
Zopa, the first online peer-to-peer lending platform was launched in the UK in 2005, and in 2006 Prosper was launched in the USA. Zopa and Prosper both remain market leaders to this day, and the industry is now a multi-billion dollar industry. There are many online peer-to-peer lending platforms around the world, including countries like China.
Why Is There a Market For Peer-to-Peer Lending?
There has always, and probably will always be people who need or want to borrow money. Whether it be a strategic decision, for instance renovating or adding onto a home they own in order to increase the value, or simply because times are tight and they need some extra cash to make it through the month.
When times are good, banks give out low interest loans quite freely, but since the financial crisis of 2008 / 2009, banks have been less able or willing to lend money to those that need it. Because of this, borrowers are looking for alternate options, of which peer-to-peer lending is an attractive one.
In addition, many of the traditional lenders, such as banks and micro-lenders, are charging high fees and interest on loans, while depositors (who effectively provide the money that the bank lends out) get very low interest on their money.
Benefits of Peer-to-Peer Lending
1. Interest rate
For borrowers and lenders, there is the attraction of better interest rates. This means lenders will earn more return on their money than if they put it in the bank and borrowers will pay a lower interest than if they borrowed from a bank or other traditional lenders.
In South Africa, it is interesting that because lending rates are capped, it is actually the avoidance of fees that makes peer-to-peer lending such an attractive option. Most micro-lenders make huge returns on their loans because they can charge substantial fees on small amounts of money. See the chart below for an illustration of the breakdown of the cost of borrowing R2000 for 10 days. The total cost of the loan is R380.50.
It is evident just from a cursory glance that the interest portion of the cost is insignificant. Less than 10% of the total cost in fact.
You can read more details on the true cost of short term loans in our article Payday Loans: Who Is The Biggest Shark of All?
This breakdown of costs is unique to the South African environment due to the regulations put in place through the National Credit Act. It is interesting to note that these fees are not compulsory. Lending institutions should be competing for business by offering discounts on these fees, and yet they all continue to charge the highest rate. This is verging on collusion and creating an environment where alternative services such as peer-to-peer lending can thrive.
2. Portfolio Diversification
For those who have money to invest, diversification of one’s portfolio is important in order to reduce the risk associated with exposure to one asset class. Peer-to-peer lending offers another viable alternative to add to an investment portfolio. In fact, in some countries, investment houses are creating loan books of peer-to-peer loans as part of their investment portfolio on behalf of their clients.
3. Responsible Investing
Particularly in South Africa, those who wish to invest responsibly, in other words not invest in companies which harm the planet or people, are struggling to find ways to get a decent return on their investments without compromising their responsible investment criteria.
Peer-to-peer lending platforms are designed to give investors insight into what the individual plans to do with the money they are borrowing, so investors can be confident that those they chose to lend money to will use the funds appropriately.
Which leads onto another benefit of peer-to-peer lending, for both the lender and the borrower. Because of the transparency around what the money will be used for and who is borrowing it, lenders can choose what ‘projects’ they would like to invest in. This has the effect of creating a crowd-funding style relationship.
Many people wish to borrow money for business purposes: either to fund a start-up or to fund the expansion of an on-going concern. In a crowd-funding scenario, lenders choose to fund those businesses or projects that they feel have potential. Conversely they can choose to avoid those that they believe are likely to fail. The benefit for the borrower in this scenario is that they receive immediate feedback on the viability of the project. If nobody wants to fund it, it becomes obvious that the project is not as promising as one might think.
Risks And How To Mitigate Them
The primary risk that peer-to-peer lenders face is that of default, when the borrower does not pay back the money they owe. There are two ways of mitigating this risk, one is performed as a service by the platform and the other is the responsibility of the investor.
The service that the platform provides is giving the investor all the information they require to make informed decisions and thereby reduce their risk exposure. Examples of information the platform would provide are:
- Credit check on the borrower
- Borrowers loan and payment history if they have used the platform before
- Information about the loan and what it is for
- Answers to questions the investor may have
The investor will be able to reduce the risk of the loan by carefully evaluating all the available information before making a loan. To further reduce the risk, the lender has the option to lend smaller amounts to a number of borrowers, rather than lending a big amount to one borrower. In other words, diversifying their personal loan book.
Peer-to-peer lending has exploded all around the world, becoming a multi-billion dollar industry in less than 10 years. South Africa is poised to follow suite for various reasons. Investors wishing to diversify their portfolios should look into social lending, and those needing to borrow some cash will find peer-to-peer lending a welcome alternative to the extortionate lending institutions out there.