Buyback guarantees are awesome - but the details matter
Many P2P investment sites offer ‘buyback guarantees’. That means, if a borrower misses payments, the original lender will buy back the loan from the investor. They can afford to overpay for these bad loans because they are charging the customer a much higher interest rate than they are paying the investor. These ‘credit losses’ can be paid for by the profits they are making on this interest spread. Across P2P investment sites the terms and conditions of these buyback guarantees can vary. Loans are normally bought back once they are 30 or 60 days overdue. This can either mean that they have failed to pay back a short term loan in full, or they have have missed a couple of monthly payments on a longer term loan.
An important check to make is whether the lender will just pay for the unpaid principal amount, or the full amount due including accrued interest. If it is just the principal amount, that means that investors will receive less than the interest rate that was published when they purchased the loan. In the table below we have listed all the lenders on the popular European investment site Mintos. While the majority pay accrue interest, several do not, and the table shows how much investor returns are impacted by this policy.
Grace periods can also dilute returns
Many lenders offer their customers ‘grace periods’. The concept is to give borrowers a little extra time to make their scheduled payments to account for things such as weekends, processing delays and so on. It can also help to improve the relationship between the borrower and lender. In most cases, if a loan is repaid in full during a grace period, no interest is usually charged between the scheduled payment date and the actual payment date. For investors who purchase short term loans, this grace period has the potential to reduce the effective yield on their portfolio as they do not benefit from interest during this period, and the percentage of loans in a grace period tends to be higher. For lenders with generous grace periods, or who have many borrowers who regularly take advantage of this window, the impact on returns can be quite material – as we show below.
What is the cost of fine print? Let's look at Mintos lenders
Below is a table that lists all of the active lenders on Mintos with buyback guarantees, whether they pay accrued interest on loans bought back, the number of ‘grace period’ days, and the % of loans in the grace period window (by balance).
The table above summarises the key ‘fine print’ terms for the active lenders on Mintos offering buyback. We’ve then estimated the impact on yield for investors.
How did we do this? For accrued interest we focused on the lenders that had a policy not to pay accrued interest. We then analysed the % of their loans outstanding on Mintos in the 30-60 day arrears status. The higher this percentage, the higher the impact on yield, as investors will be funding a higher proportion of loans that will likely be bought back and not receive 60 days of interest. We factored in typical monthly ‘roll rates’ for loans in this category, and typical interest rates, to estimate the impact on yield for investors.
For the impact of grace period, we looked at the % of loans that were currently in the grace period (effectively earning zero interest if the loan is repaid within this window) that is published by Mintos. We assumed 80% of loans in the grace period would repay before the end of the window and would effectively benefit from an interest free period.
The data provided by Mintos is limited, so as a result we have had to make some assumptions which could make the actual yield impact slightly higher or lower.
The 'fine print' can reduce expected returns by 10% or more
The table above shows that the policies of several lenders on Mintos can reduce returns by around 1.2% – that’s about a 10% reduction on a typical interest rate of 12%. That’s a big impact and shows why it makes sense for all investors to check key policies before purchasing buyback loans. If you invest in P2P loans with a buyback guarantee the most critical thing to assess is whether the lender is strong and capable of meeting its obligations (for Mintos lenders we provide ratings for example). However it is also important to check the details around anything that can materially affect investor returns, including grace periods and payment of accrued interest. The table shows that there are many lenders with policies that are favourable to investors – those who pay accrue interest and have very few loans in a grace period. Over time, investors should earn more on loans from these lenders than others with less favourable policies.
The Mintos ‘fine print’ we have published above is difficult and time consuming to find on the Mintos site, so consider bookmarking this page for the next time you are making an asset allocation on that site. For investors considering other sites, we recommend looking into the detail around its key policies – if you don’t it may cost you a lot of money when you don’t expect it. Many sites also allow you to download data into excel – this can also be a good way to check that the actual returns you are receiving are in line with what you were expecting.