P2P collateral explained
Peer-to-peer loans typically come with some form of security attached. The idea behind this is that if the borrower defaults, the P2P platform can take charge of the security and sell it in order to pay back lenders.
The most common type of security offered on P2P loans is property. For example, a small business owner could offer ownership of their business premises as collateral in order to get a loan approved. The P2P platform would then assess the property and assign it a market value. Say the property is worth £200,000, the platform might offer to loan the borrower up to £120,000, representing a 60 per cent loan-to-value (LTV) ratio. This means that even if the property market collapses, property values would have to fall by more than 40 per cent before the value of the underlying security is affected. In a worst-case scenario where the borrower defaults on a repayment and the housing market drops in value, the P2P platform should still be able to recoup the £120,000 loan on behalf of its lenders.
Read more: Why security matters for investors
Of course, property is not the only type of security accepted by P2P lending platforms. In theory, any valuable asset can be used as security.
In the past, P2P loans have been secured against yachts, luxury cars, designer watches, Birkin bags, jewellery, art collections, and fine wines, to name just a few assets. As long as the P2P platform has the expertise to assess and value the asset, it has the potential to act as security against a new loan.
However, would-be investors should do some homework to ensure that the platform has the requisite expertise to analyse the assets that it is accepting as security. A platform which specialises in property security should have a strong and experienced credit control team which includes at least one property expert.
First charge vs second charge
First charge security and second charge security are two very different things, and it is important to know the difference as a lender.
First charge security means that you have first dibs on the proceeds from the sale of any security. Also known as a secured charge, it ensures that the P2P lending platform (and therefore its lenders) will be first in the queue to receive any proceeds following the sale of the asset.
Read more: P2P bosses predict rise in unsecured loan defaults
A second charge security means that you will be second in line to receive the proceeds of the sale. A second charge loan is where the P2P lender is the second lender to offer a secured loan to the borrower. If the borrower defaults and the security is sold, the first charge lender will be repaid first, and the second charge lenders will be next in line for repayment.
Second charge lending is higher risk than first charge lending, with the main risk being that there will not be enough money leftover to make the second charge lenders whole.
For instance, say a property is worth £200,000 and the property owner takes out a first charge loan for £100,000 and a second charge loan for £60,000. Imagine a scenario where the borrower defaults on both payments and the property is sold for £150,000. The first £100,000 recouped through this sale will be directed to the first charge lenders, leaving just £50,000 out of the £60,000 owed to the second charge lenders. While the first charge lenders have a good chance of being made whole, second charge lenders may have to accept a lower pay-out. Due to the higher risk of second charge lending, the returns are usually a little higher.