Buyback guarantees in P2P lending: how do they work?
As December is rolling in full swing, we’ve prepared a special treat for our readers, or, to be precise, a special guest.
We’ve asked Sal from Revenue.Land to share his investment experience with buyback guarantees. Naturally, one can read up on the platform’s terms & conditions or go further and reach out to the platform’s support to find out about all the possible scenarios. Yet, nothing compares to first-hand experience which will definitely surprise you.
We thank Sal for this collaboration and eagerly invite you to dive in!
Security guarantees in P2P lending
Investing in infallible loans? That would be great! Too bad these infallible loans do not exist. But what if I invested in loans guaranteed by someone instead?
This does exist, it is called “buyback guarantee” but you need to know a few things about it.
When approaching the world of investing in peer-to-peer lending, the first question that comes to mind is: “How much risk do I take if I invest like this?”
Very high returns are often associated with equally high risks, so where does P2P lending rank in terms of risk?
The buyback guarantee is often mistaken for a total guarantee on the capital and returns of a P2P loan but this is not exactly the case. Let’s see why!
Buyback guarantees definition
In essence, buyback is a guarantee associated with a loan or transaction. It ensures that in the event when the borrower (the person or company that has to pay the loan) falls into arrears, the issuer of the guarantee will buy back our investment by paying us the capital invested. In some cases, it will also cover the interest that would have been due if there had been no problems.
The issuer or the company responsible for honouring the guarantee in case of troubles, is NOT necessarily the crowdlending platform (for example, the loan marketplaces) but the originator of the loan in question. This is an important nuance from the point of view of diversification and risk.
5 types of buyback guarantees
There are six different types of or buyback guarantees, each with its own particularities that should be understood before investing:
- Standard buyback
In these cases, the guarantee covers both the invested capital and the interest due and is usually activated, depending on the case, 30 or more usually 60 days after the first unpaid instalment.
- Equity buyback
The Buyback of capital, as its name suggests, is a Buyback Guarantee that only returns the capital invested, but NOT the interest that would have been due if the loan had continued to be paid normally.
- Partial buyback
The partial Buyback is a step down from the capital Buyback, as this guarantee does not even cover 100% of the capital, but only a certain percentage of it.
- Payment guarantee buyback
The Guaranteed Payment or Payment Guarantee is a formula similar in essence to the Buyback but with some characteristic nuances. In this case, instead of buying back the loan, what the issuer of the guarantee does is to continue paying the instalments as if nothing had happened, even if the borrower has stopped paying.
A priori, it is neither better nor worse than the repurchase guarantee, at least in terms of performance, although it is true that it binds you to the defaulted loans until their formal term, which can be spread over several years.
- Provisioning fund – buybacks
The provision fund or buyback fund is an alternative to the buyback guarantee.
In this case, either investors or borrowers pay a small fee on each transaction to feed a pool of funds that will return the investment to users in the event of a loan failure.
Buyback example in action
Let’s suppose that we invest 2,000 euros in a loan with standard Buybacks at 12% on a European P2P lending platform on 1 January, and that unfortunately the borrower to whom the loan is granted does not meet his first instalment, scheduled for 1 February.
Well, from 1 February we have to count 60 days, at which point the Buyback Guarantee will be activated. For the sake of simplicity, let’s assume that those 60 days are exactly two months and we will take 1 April as the Buyback activation date. So, how much money will we receive on 1 April?
Well, the 2,000 euros initially invested plus the interest that would have corresponded to us if there had been no problems with the operation.
That means 3 months (January, February and March) at 12%: 60 euros, so the platform will pay us a total of 1,060 euros and it will be as if nothing had ever happened. Not too bad, right?
Why is the buyback guarantee not the final solution?
At this point we may think that the buyback guarantee is a wonderful and infallible mechanism, right?
It is true that buyback is a very desirable feature, but it is not an absolute defence of our capital. This is something that as lenders we have to be very clear about: be careful, crowdlending is not 100% safe.
Even investing only in loans with buyback guarantee you can lose money, although it is true that if it is well executed it could reduce the risk.
In what situations can the repurchase guarantee fail?
Well, in the event that the issuer, i.e. the platform or more usually the originator of the transaction, has financial problems and goes bankrupt.
In such cases, the issuer may not be able to honour the collateral if necessary, and in the event of default by the borrower, the repurchase is not activated and we are therefore exposed to losses. That said, it is a rather rare case, but not impossible.
So, if the platforms with buyback are so interesting why should I invest in platforms without buyback? Well, I believe ignoring platforms that do not offer buyback is a mistake, for 3 reasons:
- We are limiting the diversification of our portfolio by focusing exclusively on a group of platforms with buyback, ignoring the rest and losing opportunities to bring more diversity to our portfolio.
- These platforms without buyback very often compensate for the higher probability of losses by offering higher returns, which in the long run usually implies a higher overall net return, which is what we should really care about.
- In any case, as mentioned above, buyback is not infallible.
We should not get used to this magic risk management tool, but accept that good diversification will always be the experienced crowdlender’s best defense.
From buyback guarantee to buyback obligation
Lately, the concept of buyback gradually evolving from “guarantee” to “obligation”, precisely to convey the concept that it is a contractual obligation on the part of the Originator, but in no way an infallible guarantee for the investor.