When is 6% interest not 6% interest? (Secured P2P vs Unsecured P2P)
Unsecured P2P Lending and their Provision Funds
It has been traditional for UK peer to peer lending platforms to launch provision funds. These funds are a co-mingled pool of cash which the platform pays into each time a borrower takes out a loan and they are made available to lenders should they incur a loss from their lending activity.
The cash pools are usually quoted as a percentage of the total outstanding loans made by the platform and the running balance should be in excess of either the predicted loss rate for that platform or the platform’s historic loss rate. Obviously these rates will vary from platform to platform and from year to year but it has been generally agreed through the peer to peer industry, that peer to peer lending losses are expected to be around 1.5%-2% per annum.
The main take away from this is that the provision fund is a co-mingled pool of cash and what happens if the losses on the platform run in excess of their 2% provision fund?
Secured P2P Lending and their Security
A much safer way to lend money is to have the borrower offer some sort of security to support the loan. Security can take many forms but the most reliable is by the pledging of an asset, which in the case that the borrower does not repay the loan can be sold and the proceeds used to repay the lender.
It is usual in secured lending that the value of the asset offered as security will be greater than the original loan amount. This leaves some leeway that even if the value of the asset falls, it should still be greater than the outstanding loan amount. Security is taken on a loan by loan basis and not across a co-mingled fund.
The risk of a lender incurring a loss through their lending activity where the loan is secured should therefore be much lower than if they were lending on an unsecured basis.
Security can take many forms but the safest and most traditional would be in the form of a legal charge over a property. This charge is legally documented and registered at the Land Registry. Should the borrower fail to repay the loan, then the lender is able to enforce their rights held within the legal charge and sell the property to recover money owed under the loan agreement.
If the property is owned by a Limited Company rather than an individual, then the lender may in addition insist on a Company Debenture and or a Personal Guarantee.
So secured lending offers a lender real asset security which will have a value in excess of the underlying loan amount. Think about the mortgage on your house, the lender may only lend to 75% loan to value – this means if the property is valued at £100,000 then the lender will only lend £75,000. The loan is secured by a charge on the property and there is a 25% cushion in the value of the property should the lender be required to sell the property to cover the value of the loan.
In this example the lender of the £75,000 loan would have security cover of 133% of the loan principal through the value of the property (£100,000). If the same lender had made £75,000 worth of loans via an unsecured P2P platform, that platform would in theory only be holding a 2% provision fund against those loans.
So is earning 6% p.a. interest on an unsecured P2P lending platform, the same as earning 6% p.a. interest on a secured P2P lending platform? You could argue that it is, as you are earning 6% p.a. on both but which is the better risk adjusted return?