In financial markets, the term risk usually equates to the ‘exposure to loss,’ which is measured by decisions we make. In order to measure anything, you need a standard, or a starting point, and for risk it is called the Risk Free Rate. The Risk Free Rate is the return that an investor expects from an absolutely risk-free investment over a specified period of time.
Financial institutions and economists will probably look to Government Debt as their Risk Free Rate, but the man in the street will look to the return received by putting his money in the safest place possible, a bank account. Not only is the money in a bank, but through the Financial Services Compensation Scheme (FSCS), the government guarantees that money up to £85,000, should anything happen to the underlying bank. For the average investor, the Risk Free Rate is the best rate of interest that can be earned from a bank account. After searching a well-known comparison site, a current account with no gimmicks or teaser rates attached pays about 0.5% per annum, or the same as the current Bank of England base rate.
So, 0.5% is what we can measure any other investment made against, with the difference between what the alternative investment returns and the Risk Free Rate being the Risk Premium.
In Peer to Peer lending, the Risk Premium is the difference between the interest rate you receive from the borrower and your Risk Free Rate. So, if you are being paid a Risk Premium – what are the risks you are assuming?
Lending involves two principal risks:
- Income Risk – the borrower doesn’t make the regular interest payments as they fall due during the term of the loan; and
- Capital Risk – the borrower doesn’t repay the underlying loan capital in full (or at all) at the end of the loan term.
There are ways for a lender to mitigate these risks, not totally, but to a level where the Risk Premium being paid is commensurate with the level of risk being taken.
- Understand where the borrower is earning the income which will be used to pay the interest. By lending against income producing commercial properties, the rent that the tenant pays the landlord (the borrower) is fully documented and transparent through the lease. The lease details how much rent is being paid, how often, for how long, any revisions or breaks, and if there are any guarantees supporting the tenant. It serves as a good guide for how well the borrower will be able to keep making their regular interest payments.
- Have the borrower support the loan with collateral, something that is of greater value than the loan, which can be sold in order to redeem the loan should the borrower default on the loan principal. The most traditional form of loan collateral is a property because it is a hard asset against which a charge can be registered. Clear legal framework in the UK means that real estate debt offers high recovery rates from the sale of the secured property.
Whilst Peer to Peer lending gives you the opportunity to invest in loans in order to benefit from regular enhanced returns, Proplend Borrowers support their loans with capital and income protection. This mitigates some of the risk that Lenders are being compensated for.