Recently, some people asked us about crowdlending. We’ve heard some of these questions before. That makes sense to us, as it’s one of the fastest-growing alternative investments globally. However, crowdlending is still in its infancy. There are a lot of unknowns, and the information available is sometimes murky at best. We decided to dive deeper into the subject over a few blog posts. In our first installment, we go over the basics of crowdlending.
What is crowdlending?
Crowdlending enables individuals to make loans to people and companies needing to borrow money. To help borrowers get the money, many lenders — i.e., the “crowd” — pool their money together to create the loan. In return, the lender eventually gets their money back plus interest (at least in theory).
The amount of money an investor puts with a loan varies on the platform and their preferences. In most cases, investors will lend small amounts to many different borrowers. In return, they get a diversified loan portfolio generating income.
Depending on the platform, the minimum investment amount can be as low as one euro. The borrower’s needs and profile determine the interest rate. That number can be as little as 3% and go well over 100%.
Crowdlending also goes by the name P2P (peer-to-peer) lending. In practice, there isn’t a difference between the two terms. Both connect borrowers with lenders, and both act as alternatives to banks.
Crowdlending came about in the mid-aughts, as advances in internet technology made the concept practical. It wasn’t until after the financial crisis of 2008-2011 though that the industry took off Today there are crowdlending platforms all over the world, aiming to enhance lending and borrowing. Some of the most popular platforms today are Mintos, Bondora, Crowdo, and LendingClub.
Who benefits from crowdlending?
Both investors and borrowers benefit from crowdlending. For borrowers, there are a couple of significant upsides to crowdlending.
First, and probably most importantly, crowdlending acts as a viable alternative to banks. You probably know this already, but banks love to charge high fees for their services. Somewhat coincidentally, banks also hate risk. For them, high risks mean high costs, and higher fees equals more money. It’s no surprise then that banks tend to avoid borrowers with high-risk projects and profiles.
Second, crowdlending gives borrowers an additional channel for finding loans. Borrowers are always on the look-out for the best rates available. Even if they are in good standing with a bank, there could be a better deal for them on a P2P platform.
For investors, crowdlending offers a diversification opportunity. First, there is little correlation between stocks, real estate, and P2P loans. In other words, if the stock market does poorly, it doesn’t necessarily mean crowdlending will, too. Over the long-run, that low correlation helps lower overall portfolio risk for investors.
Second, the returns from crowdlending are different from stocks and real estate. This difference brings even more diversity, which is precisely what prudent investors want.
How it works
Crowdlending platforms have two different operating models to connect investors with borrowers:
- Individuals borrow and loan money directly to each other.
- Individuals place their money into a diversified portfolio of loans.
The first model is straightforward. Konstantinos wants to borrow 1,000 EUR to buy a camera. Bettina is looking to invest 1,000 EUR. She matches with him on a P2P lending platform, which sets the terms and interest rate of the loan. Konstantinos gets the money for her camera, and Bettina earns a small profit.
The platform creates a holding or “escrow” account so that the two parties get their money. Additionally, it provides Bettina with tax information and administers the repayment with Konstantinos. If he were unable or didn’t want to repay Bettina, then the platform would step in on her behalf. In exchange for these services, the company charges the users a small fee.
The second model is more complicated. Here, the investor puts money into their account in the crowdlending platform. The platform uses some algorithms to search its loan inventory. It then matches the user with various borrowers, spreading out the funds in different loans. Since the money gets combined with other lenders, the investor can lend money to various projects.
Under this model, the investor gets a more diversified loan portfolio. This diversification means that if one borrower doesn’t make their payments on time, there’s still revenue coming in from the others. You could think of it as investing in a fund, where you spread your money across many different stocks or bonds.
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Crowdlending platforms are constantly looking for new growth opportunities. While direct “micro-loans” between users was a great start, the business model quickly evolved beyond internal clients. Now, most crowdlending platforms work with a variety of third parties across the globe called “loan originators.”
Originators act as an ‘on the ground’ agent and (should) have a banking license. They find people and companies looking for loans, assess their needs and profiles, then come back with a proposal. The originator then contacts a crowdlending platform with an offer. From there, the platform advertises the potential loan to its users. When the platform raises 90-95% of the required amount, the originator gets a notification.
From there, the originator will put up the remaining 5-10%, and the loan comes to life. Why does this company participate? The idea is that if they contribute to the loan, then they have an incentive to lend to borrowers who will pay it back. We call this having “skin in the game.” The amount of skin they put in (gross), is a good measurement of both their health and the risk of the loan.
Working with an originator comes with a couple of advantages. First, depending on their jurisdiction, the originator can claim payment if a borrower doesn’t repay their loan.
Second, some originators offer to buy back the loan from the crowdlending platform if the borrower makes late payments. In this case, the crowdlending users have a safety net, at least in theory.
Here, we covered the basics of crowdlending and how it works. If it seems like we simplified it a bit, well, we did. In practice, it’s more complicated than we’re letting on. In the next article in the series, we cover some of the risks and warning flags associated with crowdlending. As it would turn out, there’s a lot of less-than-stellar aspects to this investment strategy, ones that everyone should be aware of.
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Note that this article is for information and educational purposes only. It does not constitute financial advice.