Before giving out loans, you might want to test the waters and see how everything works instead of risking all your life savings. Investing in Microloans holds its advantages and disadvantages.
As an investor, you should not put all your life savings in one line without making tests; it doesn’t matter whether you are highly experienced in the investing sector.
Microlending is a great way to help you familiarize yourself with other lending types as you gain the relevant knowledge before increasing your investment size.
What is Microlending?
Microlending is a form of investment where people request short-term loans ranging from €100- to €2000. Most of the microlending loans last for short periods ranging between 3 days to 2 months.
Microloans are very common, and they make people addicted to investing in other Microloans without realizing it.
Microlending is another term for short term loans. Payday loans, also known as Microloans, are short-term loans that last for a few days and go for months at most.
The maturity of Microloans varies, and most have a maturity of 30 days. Depending on the loan provider and country, the annual percentage rate of short term loans ranges between 200% and 2000%.
As an investor, you should always know where you are investing your money since you want to be in a position where you can quickly evaluate the investments’ returns and risks.
This article will explain the idea of microlending fully so that you remain aware of the opportunities and risks associated with microlending.
By the time you are done reading this article, you will have the knowledge needed to invest and earn less than 10% per annum if you invest in short term investments.
Advantages and Disadvantages of Microlending
To know which type of investment is right for you, you should first evaluate the investment’s positive and negative effects.
Advantages of microlending:
1) Liquidity is high
Since Microloans are short-term loans, you will only store your capital for a short period when you invest in them.
This means the liquidity of your loan portfolio will increase. With Microloans, investors can exit the investments after a short period like weeks or days.
2) The returns are stable
Most lending companies have successfully built algorithms that help by maintaining low default rates.
To keep low rates, companies use digitalization and automatization. The low rates help by increasing the stability and safety of investments.
3) Interested payments every month
People investing in Microloans have the advantage of receiving monthly payments with interest, which adds to the compound interest effect.
In simpler terms, if you invest in your Microloans, you can always reinvest the earnings and earn additional interest on your interest.
With the advantages mentioned above, Microloans make it possible for investors to invest as little as €5.
With a lower minimum investment amount, people opting for Microloans can invest in Microloans, diversifying their portfolio hence lowering the borrower’s risk.
If you wonder where to put your €5, we strongly encourage you to read our detailed review of the best P2P lending platforms to survive the COVID-19.
Disadvantages of microlending
1) Loans might be insecure
When investing in Microloans, people are held in funding insecure consumer loans. The loans, therefore, are not secured by any collateral that can be sold and used to repay the money people invested if the borrower is not in a position to repay the loan back.
If, by any chance, the loan defaults, it might be sold to a debt collector, and the investor will receive only a small portion of their money.
Various sites offer real estate lending platforms, and if you are looking to invest in severed assets, you can go for such.
2) Borrowers are of low quality
On most occasions, people taking Microloans are supreme or prime borrowers. Prime borrowers are people who pay their loan payments at the required time and in full amount, while subprime borrowers are people who might default on their loans.
This means that sometimes the borrowers taking out the loans may have a lower score on their credit, making them unable to buy items using their credit cards or take loans from the bank.
Most people who take ‘fast’ or payday loans are more likely to have other loans like mortgages, credit card debt, or car loans, increasing their default chances.
In America, around 12 million citizen stake payday loans every year, and borrowers earn nearly $30000. Out of the total number of borrowers, 58% find it hard to meet their basic needs and monthly expenses like utility bills and rent.
Also, 39% of Americans might have difficulties in raising $400 to cover an emergency response.
Most borrowers take payday loans to cover for necessary and urgent expenses. People may take short-term loans for different reasons like broken household items like washing machines or fridges, car repair expenses, or unexpected water bills.
Borrowers who want to get such loans and don’t have credit cards might not access them. Most banks do not lend small amounts of money for short periods, making borrowers take loans from other organizations other than banks. Most payday loans are repaid in the consequent paycheck.
3) The default rates are higher
Short-term loans will always have higher default rates, and this is almost obvious. Payday loans have a default rate of around 6%, which is very high, especially when compared with other default rates. The car default rate, for instance, is 2%.
The default rate depends on the debt recovery and due diligence if the company lending the money and the country the borrower comes from. There are countries with higher default rates than others.
Countries like Kazakhstan, Spain, and Denmark have higher payday loan default rates than Sweden and other countries.
How Much Do Microloans Cost
Microloans are often associated with high-interest rates, in which the borrowers are selected to pay the lenders. Most payday loans have 200% to 2000% APRs, and many investors have said this is morally wrong.
Unlike typical bank loans, which have straightforward interest calculations, payday loans have different formulae. Factors included when calculating a payday loan’s interest vary, and the lending companies do not like sharing the recipes.
Costs incurred by the company giving loans:
- Acquiring browsers;
- Due diligence and IT infrastructure;
- Spending on customer support;
- Legal expenses and recovering debt;
- Cost of payback guarantee;
- Costs for funding;
Below is an explanation of some of the significant points from the list above
1) Due diligence and IT infrastructure
Most companies giving loans have developed digitized and automated processes to help investors evaluate whether the borrower is credible in a few seconds.
The strategies help by increasing the rate at which loans can be used, making them issuing faster than in banks.
2) Spending on customer support and recovering debts
Most online lenders have customer support services, and the people providing the services have to be paid. Other similar costs are premises costs and lending licenses.
For a lending company to be profitable, it has to cover the default rates which are expected. Huge loan volumes can achieve profits. However, the loan volumes have to be funded, and the opportunities to support them are usually limited.
4) Buyback defaults and guarantee
Lending companies account for their potential defaults because lending money to low-quality borrowers is usually a high-risk investment. For a company to provide the buyback guarantee, it needs to have the right amount of cash, and the liquidity is expensive.
Why Do Lending Companies Have High APR?
Lending small amounts of money for short periods is expensive. The APR is the annual percentage rate used even in loans that are repaid after a few weeks.
For example, for a €1000 loan taken for one month, the company will have to charge an APR of 133%. The rate is exclusive of the cost of the buyback guarantee, the profits, the extension fee, and compounding.
When everything is calculated, the investors funding the microloans will have a 10% profit in a year. This is a very fair return, especially when considering the technological implementation and the lending process.
How to Minimize the Risks Associated when Investing in Microloans
As an investor, there are several things you can do to maximize your microlending returns as you minimize the risk. Below are some of them.
- When investing in loans, look for companies with audited financial reports and a proven track record;
- Read different reviews of different platforms and settle for the platform with the lowest investment amount since you want to build a good portfolio;
- Look for countries with good payment morals for their investors and invest there;
- Invest in platforms with good customer supper and trustworthy marketplaces;
- Always remain updated with the latest news that might affect your investment.
Even if you choose to ignore all these points, don’t forget the last one.
Countries come up with stricter regulations once they realize that payday for loan companies is nearing.
Loan originators in various countries like Kosovo and Armenia have lost their lending licenses during such periods, don’t be the next one.