6 Ways To Manage The Risk of Peer to Peer Lending

02/5/08 posted by SVB at The Digerati Life

As I consider venturing forth into the realm of social finance as a lender, one of the biggest hurdles I need to overcome is my aversion to risk. But a lot of that fear comes from not being familiar with the territory. With some study and experience, dealing with peer to peer lending (or p2p lending) sounds like a promising way to put your money to use.

Some of the initial matters I’d like to learn about before I proceed with lending through Prosper or other p2p lending sites involve understanding how risk is mitigated in these environments.

How You Can Manage Your Risk With Peer To Peer Lending

#1 Know the borrower.

If you’re going to pick out your own loan listings (who you are interested in lending to), then reviewing a borrower’s story, credit scores and borrowing history are something you should weigh against the rate of return you’ll be getting from any given loan. Lenders have also gone as far as getting to know borrowers on a more personal basis before doing any lending, but you need not go this far since a lot of information may already be provided by the p2p lending site you are utilizing.

#2 Let the p2p lending mechanisms and tools help you.

Here’s a rundown of these mechanisms:

For some p2p lending sites, risk is inherently alleviated via the lending/borrowing model that is in place. For instance, in the cases of Zopa and Lending Club, you participate in pooled lending activities. According to the Wikipedia, pooled lending involves “lending your money to a pool of borrowers with similar credit ratings. In this model the risk of capital and interest for the lender is defaulters in the pool. The risk of capital and interest of the lender is reduced considerably.”

For direct lending sites such as Kiva or Prosper, other measures may be in place to assist lenders with making choices to help control their risk. In Prosper’s case, some functionality is provided that automatically builds in risk management for lenders, such as the Portfolio Plans feature. This is a convenient way of getting diversification in your lending portfolio, as well as selecting the level of risk you are willing to take.

In general, p2p lending sites normally have many measures in place to discourage defaults. If there are any issues with loan repayment, they will forward these problematic loans to professional collection agencies. Take note, however, that the statistics may not be entirely on your side since only 6% to 10% of loans are typically recovered in whole through collection agencies.

#3 Diversify.

Don’t put all your eggs in this basket. If you’re after a relatively “safe” lending experience, the tried and true approach of diversifying your portfolio also applies here. To achieve adequate diversification, the recommended MINIMUM number of loans to have in your lending portfolio has been deemed to be between 30 and 50 loans. So spread your money around when you start the process, and again, see if a site offers a way to diversify your portfolio conveniently and easily, just like Prosper does with their Portfolio Plans feature.

#4 Apply peer pressure.

Some sites, such as Prosper, have introduced the idea of “borrowing groups” so that the reputation of a borrower becomes linked to the reputation of the group they belong in. This arrangement allows people to self-manage themselves and become accountable to themselves as well as to other folks in their group. This form of peer pressure may just be the ticket to get a borrower to manage their debt more responsibly.

#5 Limit your investment, at least initially.

When getting your feet wet with any new investment, always start off small. When I begin to fund my lending accounts, I’ll be starting with a few hundred dollars to work with. I’d like to get the hang of things first and build on my experience before committing more money to this new activity.

#6 Charge interest rates that are commensurate to risk.

Easier said than done since measuring risk may not be that straightforward in this new environment. Some lenders may consider charging higher for loans in a portfolio that may contain other, riskier loans. The idea is to neutralize the effect of losses from potential defaults by tagging on additional points (say 2% to 4%) to interest rates.

Online peer to peer lending may be a new concept but don’t let the fear of the unknown stop you from trying things out.

—

The Silicon Valley Blogger (SVB for short) is behind the The Digerati Life, a blog that covers personal finance, business, investment and real estate topics along with the occasional Silicon Valley tech story sprinkled in. SVB is a married mother of two young kids who juggles a nine to five job in the IT industry along with raising a family and various entrepreneurial pursuits.

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7 Responses

Adi R | February 5th, 2008 at 10:23 am

Actually, I think you should have put #6 at #1 !

I have been consistently noting that people underestimate the risk in a blind attempt to get in on the bidding action. Often good candidates get bid down to ridiculously low interest, where Prosper itself estimates returns of 1-2% or even negative returns, once the risk is taken into account. Yet, people continue to bid it down.

Folks, look at the risk factor before jumping in on that 10% and bidding it further down! You often end up with 2% real return return or less!

RateLadder | February 5th, 2008 at 11:22 am

@Adi
While I tend to agree with you, you should be careful when quoting Prosper risk estimates.

Those estimates are for a cohort of similar loans based on credit characteristics alone.

There maybe other mitigating factors that reduce (or exacerbating factors that increase) the risk of an individual loan that Prosper cannot characterize in the generalized risk assessments.

PrivateLender | February 5th, 2008 at 7:00 pm

I would also add the following items for a new lender to consider:

(1) Lend only to borrowers in the higher credit grades with your small amount of “test money” for the first several months.

(2) Lend only to borrowers under less budget strain, such as those with lower DTI and bankcard utilization ratios.

Peer Lend | February 7th, 2008 at 12:33 am

While it’s very wise to encourage as much risk-spreading as possible, within any particular credit band and over one’s entire portfolio, the blanket claim of 30 loans being an “adequate” level of diversification has the potential to be misleading to new lenders who may not understand that while x number of, say, AA-graded loans may provide “adequate diversification”, the number of loans necessary for a relatively similar level of risk distribution when one has a portfolio whose average credit quality is lower than AA (and therefore more risky) will become larger as credit quality declines (and risk exposure increases).

I urge new lenders to click on the link in point #3 above, where they will see RateLadder advising caution (and a larger minimum number) on this same point re: diversification into a pool of loans of lower credit quality.