In recent years, two relatively new investment markets have sprung up. It’s now possible to invest in both student loans and small-business loans. Both investments present opportunities. But they also represent what are probably the two riskiest markets to invest in. Why are they so risky — and are these investments worth the gamble?
Risks of Investing in Student Loans
The direct investor market for student loans is incredibly small. The largest share of the $1.2 trillion market is issued and insured by the U.S. Department of Education. These are held by agencies like Sallie Mae and PHEAA. The next largest slice is held by a relatively small number of banks.
Only a tiny sliver is available for direct investment. And that's primarily with peer-to-peer (P2P) investing platforms, like Sofi and Common Bond. To invest on those platforms you must be an accredited investor, meeting minimum income and asset requirements.
There are two major areas of risk involved in investing in student loans.
Risk of Default
According to the US Department of Education, the default rate on federal student loans was 11.3% for 2016. The rate has dropped considerably from 14.7% in 2013. Still, double-digit defaults in any lending category represent a significant risk. Especially when you consider the single-digit interest rates typically charged on the loans.
These federal student loan defaults statistics may not apply to you as an investor. After all, federal loans are available to virtually any borrower, and there are no credit qualifications whatsoever. The default rate improves with the implementation of qualifications.
For example, Sofi does qualify its borrowers by credit and income. That means it is primarily lending to people who have stronger financial profiles. The effort shows up in a much lower default rate. Sofi's default rate on student loans is under 3%.
Now that doesn't necessarily make student loans through Sofi or any other P2P platform risk free. Sofi advertises student loan refinance rates of between 3.35% and 7.774% APR (with autopay) for fixed-rate loans. Their variable rates are between 2.31% and 7.774% APR (with autopay). When you factor in the default rate of nearly 3%, the risks become apparent.
It’s also worth considering that 3% is the default rate in an expanding economy. It's very likely the default rate will increase when the economy enters a recession, particularly a severe one.
Lack of Collateralization
It is important to recognize a second major risk factor: student loan debts are unsecured. That means there are no assets to seize and liquidate in the event of default.
Risks of Investing in Business Loans
P2P platforms are increasingly becoming places to invest in loans to small businesses. This matches investors with small business borrowers. Should you invest there? It's not without risks. But the risks are harder to decipher than with student loans.
On the other hand, business lending has several potential risk factors.
Risk of Default
The Federal Reserve puts out information on default rates for commercial and industrial loans by commercial banks. But the numbers don't translate into lending activity covering small businesses. Especially not those funded by individual investors. It’s almost certain, however, that default rates on small business loans are higher than they are for loans to institutional borrowers.
Banks Get the Stronger Businesses
While Sofi can select the best borrowers to include in its student loan refinance program, the situation is reversed with P2P business loans.
Banks get the prime business, while the P2P platforms work with those whom the banks rejected. Banks prefer business customers who are well established, have strong cash flows and strong credit profiles. Borrowers who don't qualify must turn to other sources. That's the customer base for P2P business loans.
Small Businesses Are Not Standard
Even within the small business market there is a lot of diversity. You could be lending to a doctor, a restaurant, a house cleaning service, or a landscaper, just to name a few.
Each is a unique business type. This makes underwriting loans to them an inexact science at a best. Some are seasonal. Some are relatively new. Some are in new industries. Each presents unique risks that don't lend themselves well to classification or prediction through computer programs.
Loans for Small Businesses Are Also Not Standard
The loans small businesses take are also not standard. Some may borrow to expand. Some buy real estate, inventory, or equipment. And many will borrow for debt consolidation or to shore up cash flow. Each loan purpose has a unique set of risks.
Loans Are Usually Only Semi-collateralized
Betterment advertises that loan amounts of less than $100,000 require no collateral. Some P2P lenders tie loans to receivables. Others require only a general lien on the assets of the business. Liquidating such assets would essentially mean putting the borrower out of business. And you can likely guess at the value of business assets on the open market.
Risk During an Economic Downturn
Small businesses are among the first and hardest hit during economic downturns. That means, whatever the experience rating has been during economic expansions, you can count on it getting worse in a recession. Even more problematic is liquidating collateral. Business assets, including inventory, have a way of losing value disproportionately during downturns. As well, receivables have a way of becoming uncollectible.
Should You Invest in Student Loans and Business Loans
Though the student loan and business loan markets are incredibly large, each presents a series of risks that are greater than is the case with other types of investments. This kind of investing is best left to those with a large appetite for high risk.
However, even in that case, it seems the potential returns — once you back out the default rates — are relatively small, considering the risk you are taking on.
If you do get into investing in these markets, it's probably best you do so with only a very small percent of your portfolio, say, less than 10%. Most of your money should be held in other more predictable investments.
This is true also because both student loans and business loans are very new markets for individual investors. Neither market has been around more than a few years.
Proceed if you choose to do so, but understand the risks you are taking on.