Buyback Guarantee in P2P Lending: What Is It and How Can It Secure Your Investments?
Peer to peer lending sometimes give a feeling of low level of risk. Despite this, the risk is still there and is significant enough to have some investors have second thoughts about investing in p2p lending platforms. For this reason, many peer to peer lending companies decided to take steps towards ensuring the assets of the investors in their platform are secured, and as a result, they introduced the buyback guarantee option. In a nutshell, the buyback guarantee ensures the investor’s money is secured in the event of default.
So what exactly is a buyback guarantee?
In peer to peer lending, a buyback guarantee is an agreement between the loan originator and the lender, with the aim of protecting the lender against late loans and defaulted loans from the borrower. The loan originator is the person who provides the buyback guarantee and in many Crowdlending sites, the loan with buyback option is usually marked with a shield.
The buyback guarantee works in a way that if a borrower misses making payments for a specified number of days, typically between 30 and 90 days, the loan originator is obliged to purchase back the loan, partly or fully. Depending on the structure of this buyback guarantee, it should be able to compensate the lender for their remaining principle and part or all of the interest as well as the penalty fees.
Does Buyback Guarantee Remove the Risk Entirely?
While it is a great way to give lenders some comfortability, the buyback guarantee does not get rid of the risk completely. Instead, what this option does is moving the risk to a more centralized area, which is to the loan originator. This essentially means that if the loan originator goes bankrupt, the “guarantee” will not be honored and the loan will have to exchange hands again or just be lost.
A recent example of a loan originator going bankruptcy is Eurocent in 2018. Eurocent was partnering with Mintos, the largest peer to peer lending in Europe, and when it went bust, the loans listed on the platform went bad, resulting in investors losing both the interest and the principal. But Mintos is trying to recover some of the lenders’ money that went down with Eurocent.
In some ways, the buyback guarantee in peer to peer lending is similar to a system like what was seen during the 2007 global financial crisis with AIG Insurance Company going bust on excessive gearing as well as defaults of lots of sub-prime borrowers. Thus, while it offers some sense of security, it is important to show some levels of caution when investing in a buyback guarantee loan.
How does it work?
Diving deep into the buyback guarantee, the concept works in a pretty simpler manner. P2P lending platforms or in collaboration with their partners arrange riskier loans at very high-interest rates and distribute them into small shares. They then sell these shares to the willing investors at a much lower interest rate.
Buy reselling these loans in the form of shares, the creditor can boost their liquidity and thus issue even more of these high-yield loans.
On the other hand, the loan originator keeps the difference between the interest rate given to the investor and the actual interest rate paid by the borrower.
If done properly, this could be a very good deal for the loan originator, keeping in mind that sometimes high-interest loans can be sold at 11% to investors.
What are the benefits of a buyback guarantee?
Perhaps the major benefit of a buyback guarantee in a loan is that it offers a high chance of earning the cash flow produced from investing in loans provided by the loan originator.
If there are defaulted loans, you as an investor don’t have to wait longer for the loan to be repaid or the default claim to be settled. For this reason, this type of agreement provides better certainty of the cash flow on a short-time basis.
On the other hand, there is also a high likelihood of an instant drop in cash flow in case the loan originator guaranteeing the buyback goes bust.
Should I go for loans with buyback guarantees?
When investing in peer to peer lending, you should only focus on loans with buyback guarantees; because this essentially means you will be operating on peer to peer platforms based on a four-party business model, comprising a borrower, lender/investor, the p2p platform and the loan originator. This makes the whole operation more complex than the three-party business model without an independent loan originator. It will also be a riskier business for you as an investor to operate this kind of business.
Moreover, the p2p business that involves independent loan originators includes some considerations like direct and indirect investment structure, and the skin in the game level can vary from one platform to another.
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