How does buyback guarantee work in regards to P2P lending?
In P2P lending A buyback guarantee is a guarantee provided by a loan originator regarding a specific loan. If repayment of that particular loan is delayed by more than a specified number of days (usually 60), then the loan originator is obligated to buy back the loan.
The traditional method for lending companies to acquire liquidity is to issue corporate bonds at approximately the same interest rate as they pay us – the crowdlending investors. But issuing bonds is a very expensive and inflexible solution. Instead some opt to sell loan shares with a promise to buy back those shares, should the lender stop repaying their debt.
Does it sound too good to be true?
The P2P platforms (or their partners) arrange high risk loans at very high interest rates and divide them into shares. They, in turn, sell these shares to investors at a much lower interest rate.
By reselling the loans, the creditor can increase their liquidity and thereby issue more of these high-yield loans. The loan originator then keeps the difference between the actual interest paid by the borrower and the interest rate given to the investor.
Consider the example below, where the combined interest rate is 60 % and investor receives a fixed 12 %.
This can be a very good business for the loan originator, considering that high interest loans are often sold to investors at 10 – 11% rates, But the borrower of these short-term loans often pays 30%, 40%, 70% or even higher. Although loan originator will also have to cover any delinquent debt out of their share.
Who pays such insane interest rates?
Many people do.
Consider a borrower who takes out a payday loan of € 1 000, agreeing to repay € 1 050 the following month. That’s a 60 % annual interest rate.
High interest rates are due to high risk, and that of course also means that many borrowers never pay, or they only pay part of their debt after a lengthily legal procedure. But with buyback guarantee, that’s not the lender’s problem.
However, as loan originators keep most of the interests, your expected returns will be lower for loans with buyback guarantees than for those without it. You are essentially paying for security in the form of buyback guarantee.
Should I choose buyback guarantee?
That depends.
You don’t have to go for loans with buyback guarantee. You can bypass the loan originator and keep all the interest to yourself. That’s how Bondora works. There you can choose to buy high risk/high return loans. Often at 50 – 200 % interests. But you also expect many of these loans to default.
Some prefer these high risk loans, because they provide the opportunity for very, very high returns. Others want a steady ~11 % annual income with limited risk. Others again prefer to diversify by setting up a portfolio with a mix of high- and low risk loans.