Wednesday, 24 July 2019

Understanding P2P interest rates and how they are set


With the Reserve Bank of Australia having recently cut the cash rate to a record low of 1%, I thought it prudent to delve into how Peer to Peer platforms set their interest rates and if the cash rate has an impact on the rates we can expect as an investor.  For this I will focus on three platforms, TruePillars, RateSetter and OurMoneyMarket and highlight the key points of the Product Disclosure Statements (PDS) around how interest rates are determined.

TruePillars

This platform focuses on loans to small and medium sized businesses with terms of up to 5 years.  Every application has an assessment completed to risk rank the application and assess if the business has the capacity to repay the potential loan.  This is done through a combination of quantitative and qualitative data supplied by both the borrower and third parties.  Some of the key data points that feed this rating include

  • External credit agency data and score
  • Industry sector & geographic region
  • Nature, size and age of business
  • Management team and track record
  • Financial statements and bank account data
  • Commercial invoice payment performance
  • Court Judgements and bankruptcies (current and historical)
  • Proprietors/director’s consumer credit information
  • Key macro-economic indicators

Based on the outcome of this analysis a decision is made to either progress the loan or not.  If the loan is progressed to Auction, a risk ranking is applied from 1 to 5 (5 is the highest ranking / lowest risk borrower). 
Approved borrowers are listed on the reverse auction site with upper and lower limits on the interest rate to ensure investors are appropriately compensated for the risk borrower poses even if demand from investors for the loan is high. 

RateSetter

This platform provides both consumer and business loans.  RateSetter completes a credit risk assessment to determine the borrower’s creditworthiness.  This process is broken into three phases; Application Assessment, Risk Assurance Charges and Credit Assessment.
The Application Assessment is the first pass credit assessment based information provided by the applicant and third party credit reports.  An applicant may not progress past this step based on the outcome of their risk profile.
If an applicant does progress, a Risk Assurance Charge is determined based on the borrowers expected risk of default.  Note on this platform investors are not paid a premium when lending to risker borrowers (nor do you know if you are lending to a risker borrower).  Instead borrowers pay a risk assurance charge that goes into a provision fund that is used to compensate investors in the event of borrower defaults.  The higher the risk of the borrower the more they are required to pay into the provision fund.
The last phase is the credit assessment, which takes a more detailed review and confirmation of the applicant’s details.  This may include, but not limited to:

  • Verification of the applicant’s identity
  • Confirming employment status
  • Verifying living expenses and other debt obligations
  • Assessing applicant’s income is sufficient to meet living expenses, existing and new loan obligations without causing hardship 
  • Confirming security for the loan (if applicable)

A similar process to the above is applied to business loans with a focus on the business financial health and ability to service the loan.
The final interest rate is set by investors and borrowers on RateSetter’s open market platform.  Market supply and demand influences the final rate investors and borrowers agree to. 

OurMoneyMarket

This platform provides consumer loans up to a 7 years in length.  Interest rates are determined by the Interest Rate Committee whose objective is to set competitive rates to borrowers whilst providing competitive risk-adjusted returns for investors.
The committee consider a number of factors including

  • General economic environment
  • Estimated default rates per loan grade
  • Loan terms
  • Competitive factors such as rates set by other marketplace lenders and banks

From there interest rate bands are assigned to the loan grades A+ to D with A+ loans determined as the highest rating (lowest risk) borrowers.
The credit history of individual borrowers determines the loan grade that is applied and based on their unique circumstances and credit history a personalised rate (with the band) will apply.  This fixed rate loan with the relevant details on risk is offered to investors for funding.

As you can see, platforms utilise different methods for setting interest rates based around a credit assessment of the borrower.  Although there is no direct reference to the RBA’s cash rate, there is reference to economic conditions which typically would include cash rate movements.  So while a rate cut does not automatically mean a reduction in returns to investors, there is the possibility that returns may reduce to match the new economic conditions. 

From my general observations, I have perceived reductions in returns on TruePillars and RateSetter although these happened prior to the RBA cuts and appear to be driven by demand from investors and not related to a drop in the cash rate.  In contrast OurMoneyMarket rates appear to have remained stable to date.  I believe this because the final interest rate paid by the borrower is not affected by the demand from investors as is fixed as part of the credit assessment.  Interested to hear other people’s thoughts and observations on interest rates and returns received from Peer to Peer platforms.

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