Frazer’s Blog- The Relationship Between Risk and Reward
The bridging finance market that we operate in is a highly competitive and has become even more so in the last 12 months.
High-quality borrowers with low loan to values on their secured property typically pay around 5-8% to lenders.
We can access borrowers such as these and there have been a number of such deals published on the website over the past few months. However, the interest rates payable to investors are much lower than usual and they have not proven as popular with investors.
It’s a fact of life you cannot have your cake and eat it. Our investors have made it clear to us that they prefer to be paid a higher rate of interest 8-10% and with that comes a higher level of risk and a greater number of defaults. In order to achieve the rates we pay investors we focus on what can only be described as the riskier end of the market.
Having said that we, of course, do everything within our power to ensure your money is protected. We look at well over 80 applications a month and only proceed with about 15 applications.
We then undertake thorough due diligence on the borrower and the secured property working with solicitors and RICS surveyors and this gets whittled down to just a few loans a month.
Because our borrowers are sometimes classed as ‘sub-prime’, defaults are more commonplace and sometimes, repayments have been delayed. In a few cases, we have had to take possession of the property and sell it to recover investors’ money. To date we have not incurred any losses to capital but this is a risk and you should be aware that it can happen if, for example, the market has fallen considerably, as it has in London recently, the valuer has not valued the security properly or something else occurs that our due diligence could not have reasonably prevented.
Making these loans is NOT akin to having a savings account and you should only make them if you are comfortable with the risk that a borrower may default and your capital is at risk.
Before we go any further, let’s break down the basics of what a default is and how it affects your investment.
So, what is a default?
A default simply means that a loan has passed its due date for repayment. It does not mean that you’ve lost any money. A clear majority of defaults are resolved by the borrower paying the money back after the due date. We work with the borrower to help sell the property or refinance it to repay investors and in the meantime, our solicitor will commence the necessary legal enforcement process.
Why do defaults happen?
Before we agree to work with a borrower, we always ensure that they have a clear and credible exit strategy.
Most defaults are either a sale falling through, things simply taking longer than expected or a result of unforeseen circumstances – events that neither we or the borrower could have foreseen (no matter how hard you rub that crystal ball) including deaths and divorce too.
How do our default rates compare to others?
Our default rates are significantly higher than say a bank would expect from mortgages to homeowners. They are, at the time of writing, 22%. According to our contacts and our broker network, these default rates are not unusual and are approximately the same as other peer to peer lenders that operate at the same end of the market. To stress again that simply means the borrower has not repaid in the agreed time not that investors have lost money.
With high returns comes a higher risk. We strongly advocate diversifying your capital over a number of secured peer to peer loans to mitigate the risk of default.
Is a default good for my return?
Over the past month (June 2018) we have had 4 loans redeem, 2 of which were early. But when a default does happen, how badly is it going to affect your return? In a perfect world, every borrower would pay back their loan on time. As we’re sure you’re aware, things aren’t always perfect. Sometimes, things just don’t go to plan. In instances such as these, we must resort to charging a penalty interest. When a loan does go into default, your interest rate automatically increases until the loan is redeemed. If you want to learn more about our peer to peer loans and the associated underwriting procedures. Please refer to our underwriting manuals for full details..
Risk and reward
What impact does an LTV have on our secured peer to peer loans? Quite a lot, actually! An LTV may be understood as a lending risk assessment. At The House Crowd, a loan to value is an assessment that outlines that value of a borrower’s loan against the value of the property to which the loan is secured against. The lower the loan to the value of the property, the higher the protection offered to the investor.
Would a low LTV reduce the default rate? Of course!
Lowering the LTV on our peer to peer loans would without a doubt have an impact on the default rate. But, it would also significantly lower the returns that we are able to pay you to around 4 or 5%. This sector of the market is highly competitive with banks and mainstream lenders winning most of the business.
We are doing what we can to source higher quality borrowers and loans with lower LTVs for those who would prefer a lower risk investment.
Spreading your risk
As most people would agree, diversification is a sound strategy when making an investment. After all, if you put all your eggs in one basket, it’s far more likely that the handle is going to snap.
As such, it is a sensible idea to consider including loans with a lower Loan To Value within your investment portfolio- even if they do pay a lower rate of interest.
Alternatively, we have introduced two new products over the last 6 months enabling you to automatically spread your capital over a wide range of loans giving you a healthy level of diversity