If you’re new to investing in loans, you’ve come to the right place! This article provides an introduction to the loans asset class and what it means to invest in loans – including the benefits for you as an investor.
Investing in alternatives: The new normal
From cryptocurrencies and NFTs to collectibles such as art and wine, alternative investments have become the new normal. Why? Other than the diversification benefits that they provide, it’s never been easier or more affordable to invest in alternatives.
One alternative that’s gained more popularity in recent years is loans, a type of debt-based investment, where an investor pays a lump sum and receives fixed repayments plus interest in return.
Traditionally, bonds, certificates of deposits, and annuities were the only debt-based investments an investor had access to. But as the fintech sector evolved, so did the availability of all sorts of loan investment opportunities. And now, thousands of investors across the world include loans in their portfolios.
In terms of how people invest in loans, there are a few different models. Within the crowdfunding sector, the models of peer-to-peer (P2P) and marketplace consumer lending are the most prominent alternative finance models in the world1.
The P2P model allows individuals to directly lend and borrow from each other – all through an online platform. Whereas, the marketplace lending model connects investors to already existing loans from alternative lenders – with interest rates higher than those being offered by traditional banks. In essence, both of these models have allowed people to invest in loans without the presence of traditional financial institutions2.
In addition to these, another model has emerged as the asset class shifts towards regulation – investing in loans through financial instruments, otherwise known as securities. This means investors can participate in the loans asset class in a fully regulated environment and benefit from investor protection laws, which are the same as when you invest in other securities such as stocks.
Characteristics of the loans asset class
Unlike many other investments, entry into the loans asset class is simple – meaning anyone can participate as an investor. The initial investment amount can be very little, and because of this, it’s easy for investors to create diversified portfolios (which can help reduce investment risk).
As the borrowers of loans range from everyday individuals to small businesses, the time frame of a loan investment can range from 1 month to multiple years. However, sometimes they can be extended or repaid early. During this time, investors expect to receive regular interest payments on top of the loan repayments.
An example of the lifecycle of a loan investment:
- A lending company issues a loan to the borrower from its balance sheet. The borrower receives the loan as a bank transfer or in cash.
- The lending company makes the loan available for investors to invest in.
- Investors invest in fractions of the loan.
- As the borrower repays the loan, the investors receive repayments on principal and interest on their investment.
If an investor wanted to sell a loan investment early, some platforms (such as Mintos) offer secondary markets, where investments can be sold directly to other investors.
Why invest in loans?
Compared to other debt-based investments, such as bonds, loans are performing quite differently in today’s investment market. Bond returns (especially once adjusted for inflation), are at historic lows and even negative in many areas, such as Germany – meaning investors are making losses.
So for investors seeking debt-based investments with higher return opportunities, loans can be an attractive alternative. Loan investments made on the Mintos platform (which has over 40% of the market share in Europe)3, for example, have generated an average annual net return of 8.6% for investors from 2017 to 20214.
Importantly, loans, like all types of investments, are not immune to investment risk, so investors need to ensure they align with their own risk appetite and investment goals. To avoid some of these risks, many investors implement risk-reducing investment strategies such as diversification.
When it comes to creating a diversified portfolio, alternative investments, and loans, in particular, have proven to be valuable portfolio additions. This is because loans don’t tend to follow the behavior of traditional investments such as stocks and bonds in the investment market5. For example, if the stock market drops, loans aren’t likely to follow suit.
But it’s not only investment portfolios that the loans asset class has benefitted – it’s the borrower market too.
An asset class contributing to financial inclusion
The alternative finance sector has been providing opportunities for those who are excluded from the traditional banking system – whether it be households or small to medium enterprises1.
In Europe, it’s estimated that 27% of clients are underbanked (have limited access to financial services). And a further 11% are unbanked (have had no previous access to financial services) – a group particularly prevalent in South and Eastern Europe1.
So collectively, the sector has been combating issues of financial inclusion in emerging and developing markets across the world.
Among all the alternatives that have emerged over recent years, loans represent a highly accessible asset class that’s pushing the boundaries on traditional debt-based investment returns. So if you’d like to further diversify while earning passive income, you may find loans to be a worthy addition to your portfolio.
If you’re considering investing in loans, check out the ways of investing on Mintos.
- Cambridge Centre for Alternative Finance, University of Cambridge Judge Business School (2021) The 2nd Global Alternative Finance Market Benchmarking Report
- Tang, H. (2019) Peer-to-Peer Lenders versus Banks: Substitutes or Complements?
- EU Peer-to-Peer Lending & Equity Funding Volumes | P2PMarketData
- Net investment return is defined as the total annualized gross return, minus the annualized loss rate. Write-offs have been applied to the loans issued by suspended lending companies based on our recovery estimates.
- Aue, T. G. (2020) Do P2P Loans provide Diversification Benefits in Multi-Asset Portfolios?