Investing in Microloans
When starting out with P2P lending, you might want to test the waters first, instead of putting all your life’s savings on the line - although, of course, you shouldn’t ever do this with any investment you make… no matter how skilled an investor you are. Instead, microlending might be just the right solution for you to get familiar with P2P lending, and gain invaluable experience before increasing your investment (sensibly, of course).
Hold on! What’s microlending?
Ah, we’re glad you asked. Let us tell you…
Microlending is a common form of investment in short-term loans (normally €100 - €2000) that typically have a duration of between 3 days and 2 months. Microloans are, in fact, so common that many P2P investors invest in microloans without even realizing it.
In this guide, we will introduce you to the concept of microlending, so you are fully aware of all the risks and opportunities that come with it.
At the end of this article, you will have all the knowledge that you need to earn at least 10% interest per annum on your short-term investments.
This comprehensive guide will cover the following:
What is Microlending?The Facts:
Short-term investments in the P2P lending space can be referred to as microlending. Microloans (also referred to as payday loans) are short-term loans with a duration typically between a few days and two months. The majority of the microloans have a loan maturitywithin 30 days and the loan amount is usually between €100 and €2000, depending on the countryand the loan provider. The annual percentage rate (APR) is typically between 200% and 2,000%.
An investor should always know where they invest their money to be able to evaluate the risk and returns of their investments.
Pros and Cons of Microlending
Let’s break this down. A great way to decide if a form of investment is right for you, is to have a quick look into the positives and negatives associated with it...
Pros of Microlending
- High liquidity
- Stable returns
- Monthly interest payments
- Broad diversification options
As mentioned above, microloans are short-term loans, meaning that if you invest in those assets, you will only lock your capital for a short period. This increases the liquidity of your loan portfolio, meaning that if you decide you want to exit your investments, you can do so within a few weeks or even days.
Thanks to automatization and digitalization, lending companies were able to build algorithms that help keep default rates low, which in turn increases the safety and stability of investments.
Monthly Interest Payments
Investors who invest in microloans receive the principal as well as interest payments on a monthly basis, which adds to the compound interest effect. To put it simply, if you decide to invest in microloans, you can reinvest your earnings and earn interest on your interest.
Broad Diversification Options
The mix of the above-mentioned benefits enables investors to invest in some microloans with a minimum investment amount of €5. The low minimum investment amount means that, should you choose to invest in microloans, you will be able to broadly diversify your portfolio, which ultimately lowers the default risk (borrower risk).
Learn more about this in our ultimate guide about the safety of P2P investments.
Cons of Microlending
- Unsecured loans
- Lower quality borrowers
- Higher default rate
When you invest your money in microloans, you help to fund unsecured consumer loans. This means that loans aren’t secured by any collateral that could be sold to repay the debt, in cases where the borrower is unable to pay the loan back.
If the loan defaults, it will likely be sold to a debt collector and you might only receive part of your investment back.
If you want to invest in secured assets, you should be looking to invest your money at one of the real estate P2P lending platforms.
Lower Quality Borrowers
People who take out microloans are usually prime or subprime borrowers.
According to Experian, “Prime borrowers are candidates who are considered most likely to make loan payments on time and in full, while subprime borrowers are considered more likely to default on their loans”.
If we are to take Experian’s definition as fact, this means that the borrowers who take out those loans have a lower credit score and often aren’t able to take a loan from the bank or buy items with their credit cards. People who take payday loans or ‘fast’ loans most likely also have other debts such as a car loan, credit card debt, or a mortgage which increases the risk of default.
A 2019 Forbes article reveals that “As many as 12 million Americans take a payday loan each year. Borrowers typically earn about $30,000 per year, and 58% of them have difficulty meeting basic monthly expenses such as rent and utility bills, according to the Center for Financial Services Innovation. (An even greater share of Americans — 39% according to the latest Federal Reserve survey — would have trouble coming up with $400 to cover an emergency expense.”
Borrowers typically use payday loans to cover urgent and necessary expenses. Reasons to take a short-term loan include paying for unexpected water/electricity bills, car repair expenses or bills to replace broken necessary household items (for example, a fridge or a washing machine).
Borrowers who aren’t able to get their hands on a credit card are often not able to cover those unexpected expenses. Banks typically don’t lend small loan amounts for short periods, which is also the reason to take a loan from a non-bank lender. Ideally, the payday loan is repaid with the next paycheck.
Higher Default Rate
It’s no secret that short-term loans come with higher default rates. The real default rate for payday loans is around 6%, which is high, especially when compared to the default rate of personal and car loans (which is historically around 2%).
The default rate is also highly dependent on the due diligence and debt recovery of the loan originator (lending company). The default rate also varies depending on the country of the borrower. According to an article from Mintos, the default rate for payday loans in Denmark, Spain and Kazahstan is higher than it is for similar loans in Sweden.
Breaking Down the Cost of Microloans
Microloans are notoriously known for their high APRs - the interest rate the borrowers need to pay on their payday loans - which are typically between 200% and 2000%. Many investors consider this as morally wrong.
Calculating the APR of a payday loan is not as straightforward as it is with typical bank loans. There are a lot of factors to include when calculating loans’ APRs, and lending companies aren’t very open about sharing their ‘secret’ formulas.
Let’s have a look at all the possible cost factors involved with microlending:
Cost for the Lending Company
- Borrower acquisition
- IT infrastructure and due diligence
- Customer support spending
- Debt recovery and legal expenses
- Fee for the buyback guarantee
- Funding costs (fee for the P2P lending platform)
We’ll look into the most important factors from the list above in more details here:
IT Infrastructure and Due Diligence
Most of the loan originators have built an automated and digitized process that gives investors the ability to evaluate the creditworthiness of the borrower within a few seconds. This helps to increase the pace at which loans can be issued, and many are therefore issued quicker than banks’.
Developing this system, while adjusting the credit risk criteria to the current market situation, is expensive.
Spending on Customer Support and Debt Recovery
Many online lenders provide customer support and therefore the people in charge of this service need to be paid. Other costs might include lending licenses and costs for premises as many lenders also have their offline branches.
It’s no secret that, in some countries, lenders charge ‘low’ interest but extraordinary fees for additional services. These services include loan extensions, fast payout, or a credit score certificate - which is often required for the borrower to be eligible to receive the loan. This is particularly common in countries where regulators cap the maximum APR.
In order to be profitable, the lending company also needs to be able to cover the expected default rates. Profitability can often be reached by huge loan volumes, but these loan volumes need to be funded, and funding opportunities are often limited.
In fact, many lending companies will only invest around 5% or 15% of their own capital into their loans. In the P2P lending space, this is also called ‘Skin in the game’. The rest of the funds are provided by institutional or retail investors.
Investopedia defines these investors as follows: “An institutional investor is a person or organization that trades securities in large enough quantities that it qualifies for preferential treatment and lower fees. A retail investor is a non-professional investor who buys and sells securities through brokerage firms.”
In order to obtain the funds from retail investors, the lending company either lists their loans on a P2P marketplace or they build their own P2P lending platform. Both options come with additional costs for the lending company. P2P marketplaces such as Mintos charge a fee to the lending company in exchange for the volume of funds they are able to provide through retail investors.
Buyback Guarantee and Defaults
Lending money to lower-quality borrowers are considered high-risk investments, which is why lending companies need to account for potential defaults.
Additionally, many loan originators offer a buyback guarantee to retail investors. This means that the company will buy back the loan if the borrower repayments are delayed by more than the agreed number of days (usually 30 or 60 days). Learn more about the buyback guarantee here.
In order for the lending company to provide this buyback guarantee, it needs to have enough available cash and liquidity is expensive.
Why is the APR so High?
As outlined above, lending a small amount of money for a short loan period is expensive. The APR represents the annual percentage rate while the loans are being paid usually within a few weeks.
Let’s represent this in a simple example:
- Loan amount: €1,000
- Loan period: 30 days
- Operational cost: 5%
- Default rate: 6%
The finance charge in this scenario is 11% which equals €110.
Simplified APR calculation to cover the fixed costs and defaults according to consumerfed.org:
Step 1: Divide the finance charge by the loan amount (110 / 1000 = 0.11)
Step 2: Multiply the result by the number of days in the year (365) = 40.15
Step 3: Divide the answer (40.15) by the loan term (30 days) = 1.33
Step 4: Multiply the answer 1.33 by 100 = 133%
In order to only cover the operational costs and default rates of a €1,000 loan for one month, the lending company needs to charge a 133% APR.
This does not even include compounding, fees for extensions, profits for the lending company, and the cost of the buyback guarantee.
At the end of the calculation, the investors who fund microloans receive a net profit of around 10% per year.
Considering the complexity behind the lending process and the technological implementation, this is a very fair return on your investments.
But, like all investments, it’s not risk-free.
Minimizing the Risks of Microlending
To get an overview of the most important risks connected to microlending, read our recent article about the safety of P2P investments.
There are a few things you as an investor can do to minimize your risk and maximize your returns.
How to increase the safety of your short-term investments:
- Invest in loans from established loan companies with a proven track record and audited financial reports
- Read lots of platform reviews and invest on those with low minimum investment amounts so you can build a well-diversified portfolio
- Invest only in countries where borrowers have a good payment moral
- Invest on trustworthy P2P marketplaces or P2P platforms with good customer support
- Stay up to date with the latest news that might affect your P2P investments
The last point is especially important. It is not uncommon for certain countries’ regulations around payday loan companies to be getting stricter. Several loan originators have already lost their lending licenses in countries such as Armenia or Kosovo.
Regulators across several countries are capping the maximum APR rate which forces certain lenders to leave the market. Retrieving your investments back might be a long-lasting and often frustrating process which is why you should diversify your investments to minimize those losses.
Where to Invest in Microloans
As we mentioned earlier, many P2P investors invest in microloans without even realizing they’re doing so. As microlending isn’t as popular, P2P platforms refer to this as P2P lending.
It’s not uncommon that P2P lending sites brand themselves as companies that list investment opportunities in consumer or personal loans.
While this might be true, most platforms list primarily payday loans and, by now, you should know that there’s a difference between those loan types, at least in the default rates.
Listed below are Europeans’ most popular investment platforms; you can invest in microloans on all of these platforms. Most of the platforms are available to investors from any country; the only requirement is that investors must have a European bank account. You can easily open a digital bank account with services such as Transferwise or Revolut.
We use Revolut, N26, and Transferwise borderless accounts to transfer funds to various P2P lending platforms.
|P2P Platform for Short-Term Investments||Average Yield for Investors|
Want to read more about these platforms? Simply click on the platforms you’re interested in and you’ll be taken through to our individual and very comprehensive reviews, where you can get a better idea about the platform’s functionalities.
Note, that many of the above-mentioned platforms also offer investment opportunities in different loan types. In order to invest in short-term loans, you will have to set up your automated investment strategy in a way where the platform only invests in loans with a short period.
Currently, our most preferred P2P platform for short-term investments is PeerBerry. This P2P marketplace lists loans from reputable lending groups such as Gofingo and Aventus group. All the loans are covered by a 60-day buyback guarantee from the individual loan companies as well as the group guarantee from the parent group. You can read our PeerBerry review here.
Microloans are often perceived as a rather controversial loan type and we understand why. If you are, however, someone who really enjoys the high liquidity rates when investing, there is currently no better loan type that provides you with this benefit.
Neither Personal loans, real estate loans nor business loans provide the high liquidity that payday loans do, which is the main reason why the majority of investors invest in short-term assets.
It’s up to everyone to decide where they invest their money. At the end of the day, P2P lending isn’t risk-free but it also isn’t as volatile as the stock or crypto market. With average yields of around 10% per year, P2P lending is an interesting investment alternative for many retail investors.