Many investors believe that stock market is the invincible investment option when comparing annual returns in the long run. A common assumption is that stock markets offer on average at least a 7% annual return over time. According to the Credit Suisse Report (Global Investment Returns Yearbook 2018), the average annual return on stock markets has been 5.2% globally and 4.3% in Europe from year 1900 to 2017. During the same period, the average annual return on bond markets has been 2% globally and 1.3% in Europe.
Unfortunately for peer-to-peer (P2P) lending there is no long history data as the investment alternative is fairly new. However, in the US, the average annual return on peer-to-peer lending has been around 4.3% and 5.5% in UK since 2011 (source: Brismo Market Data and Orchard US Consumer Online Lending Index).
Fellow Finance’s peer-to-peer lending platform has provided around 10% average annual return since 2014 (on Finnish consumer loans). Cumulatively the return has been over 44% whereas the Euro Stoxx 50 index has fallen to -2.04% on the same period.
Investor returns shows with TWR-method calculated profit index to all Fellow Finance –service investments calculated together. Investments’ value is defined as open loan capital decreased by credit loss reservation. Credit loss reservation is calculated daily based on loans’ payment delays, realization value and risk class. During the period 7/2014 - 11/2016 the credit risk reservation is an estimate because of the change done to the calculations. Historical profit isn’t a promise for future profits. Comparison index in the graph does not include dividend.
Every investor should be aware of risks that investing always includes like partial or total loss of capital and peer-to-peer lending is not an exception. Investment risk may be understood as a variation of the received return compared to the expected return. The key risks of investing through our marketplace is the payment default of a borrower (credit risk), the received return differing from the expected return (interest rate risk), a risk related to the time which is needed to sell a loan on the secondary market (liquidity risk) and changes in exchange rates on a loan period (exchange risk).
Risks of different investment options can be compared by a volatility key figure - standard deviation of return. Low volatility stands for steady return. The figure below illustrates the risks associated to different investment options. The same outcome can be seen from the figure above where the stock market index Euro Stoxx 50 has fluctuated widely while the return of investing in loans has been steady.
Often investors compare returns on peer-to-peer lending to stock market returns. Using volatility as an indicator for comparison, it would be preferable to benchmark bond markets to peer-to-peer lending due to the similarities of these two assets rather than stock markets. Peer-to-peer lending through our service has had lower volatility compared to Corporate Bond index.
Investor return is affected by interest rate of a loan, payment behaviour of a borrower, success of a collection process and finally by a sale of unpaid loan to a collection agency. In Finland and Poland, we sell non-performing consumer loans after 90 days of delinquency to collection agencies regularly and will set up a similar arrangement for Swedish consumer loans as well.
Currently the debt sale prices for the open loan capital of non-performing loans are:
If the interest rate level of loans and the ratio of delinquent loans to the performing loans in the loan book will remain on a current level, the change of the debt sale price will decrease investor return by 1 percentage point.
The main investing risk is related to a situation where a borrower does not pay his loan back to investors as agreed. Credit risk can be reduced by diversifying investments to as many borrowers as possible and between different loan markets (Finland, Germany, consumers, businesses etc.). The rule of thumb for diversification is to acquire a loan portfolio containing at least 100 loans per loan market.
If a borrower does not repay his loan to investors despite payment reminders, the loan will be sold to a collection agency. Historically the share of loans sold in debt sale in Finland is diminishing, which has caused a decrease in realized credit losses. From 2016 the average realized credit loss of an investor has decreased from 3.5% to 1% when the debt sale price has been 70%. The realized credit loss in Finnish consumer loans was approximately 1.7% of the loan capital in 2017. Had the debt sale price been 53%, the realized credit loss would have been 1 percentage point higher, 2.7%.
With the new debt sale price and the change of the collection agency, we are going to have access to the debt information database as one of the first companies in Finland. This will enable us to obtain more information on loan applicants like current debts, even if the person has no public default information. We believe that this additional information will help us to reduce the amount of loans to be sold, prevent over-indebtedness and thus keep credit losses down also in the future.
Because credit losses affect returns of investment, it is advisable for every investor to regularly review own interest rate requirements of the loan allocators and when making loan offers manually. It is also worth of mention to inspect from time to time the adequate diversification of loan portfolio on every active loan market and consider opening new loan markets for even better diversification.
When comparing the returns between different investment options and different investment service providers it is important to compare apples to apples. The simplest and perhaps the most common way is to compare the amount of initially invested capital to the present amount of capital. The issue becomes more complicated or, at least the comparability may be blurred when using non-comparable key figures i.e. key figures that are calculated with different methods. We have noticed that some service providers present the return on investment as the received interests in respect of the invested capital without credit loss reservation for overdue loans. Further, often only the nominal interest rate is presented to investors. Naturally returns gained from our platform may face return comparison to other services although return key figures between different services may be non-comparable and therefore we believe that it is important to set out our method of presenting returns to the investor.
We present internationally used equation (Internal Rate of Return, IRR) to calculate return on loan investment. Factors that are considered when calculating returns are received interests, realized credit losses, capital gain and losses from selling loans on the secondary market as well as the current loan capital minus credit loss reservation for overdue loans. This way we inform investors about the possible impacts of non-performing loans to the return on investment in the future.