Question

In: Economics

Write an essay on the following topic: Discuss the factors that the two households described in...

Write an essay on the following topic:

Discuss the factors that the two households described in Table 3 should consider when reviewing their savings and investments, drawing on the module materials and in light of the economic context described in the news extract (Extract 1) provided.

Table 3  Demographic and financial characteristics of two households

Demographic characteristics Financial characteristics
Household 1 Married person, aged 55 In a well-paid job. Saving for retirement through a portfolio made up mainly of shares (75%) and the remainder split fairly evenly between peer-to-peer loans and cash.
Household 2 Working couple in their early 30s, no children Both earning a bit more than the national average. They have recently started saving to buy a home in three or four years’ time. They are beating the low returns on savings accounts by investing instead in peer-to-peer loans.

Extract 1

Are peer-to-peer loans right for your portfolio?

Peer to peer (P2P) lending has taken off in recent years. Various fintech companies such as Lending Club, Prosper and Funding Circle and many more have shown that there’s a business directly connecting those that are looking to borrow with individuals willing to lend. This is previously a business that was mostly operated by banks themselves lending their own money to their own customers. With peer to peer certain borrowers can potentially see lower interest payments and lenders may get a better return on their money than with other types of debt. Here I am discussing the lending side of peer to peer loans, so peer to peer as an investment strategy, rather than as a way to borrow…

The critical point with any sort of lending, and most longer term investments that involve economic risk, is that you should evaluate returns through the entire economic cycle. As Warren Buffet said, ‘Only when the tide goes out, do you discover who’s been swimming naked.’ Often peer to peer debt is issued for several years and so earning a, say, 9% return in one year is great, but if the next year the loan defaults and you lose the full value only 1 year into a 3 year loan term, then that temporary 9% return is not so attractive. You’ve lost money. This is because debt investing even high single digit interest rates won’t help you make money, if even 1 in 10 of the loans default. Of course, often peer to peer sites encourage you to diversify by owning a small piece of a large number of loans, and that can help make your returns more predictable, but how returns vary over time, particularly in recession, may be just as important…

Solutions

Expert Solution

Peer-to-Peer lending is an effective way that enables individuals to obtain loans directly from other individuals cutting out the financial institutions as the middlemen .

These crowd lending websites directly connects borrower to investors .The loan applicant posts their financial profile along with the interest rate they are willing to pay . The loan provider reviews the profile and chooses an offer. The money transfers and monthly payments are also handled through these websites platforms.

It must be understood that the four prime segments for P2P lending are students , real estate , small businesses and consumers. A United Kingdom lending Company Zopa has a 4.5% defaulting rate . Another UK company quackle closed down with a near 100% defaulting rate . Even in United States this type of lending is legally treated as investment however it's repayment in case of borrowers default is not guaranteed by Federal government.

If we talk of the first category of households , they have a residual income of 25% which they fairly distribute between two options . Now let us consider that they earn $1000.

Thus the remaining amount would be $250 only and an equal split between two options and with a interest rate of rate of 9% and risk rate of 10% the interest rate amounts to merely 1.125% (125*9%=11.25, 11.25*100/1000=1.125)  of the total income while the risk rate is 12.5% of the total income , thus this option is not viable for household 1.

Now let us see the case of household 2 they are earning little more than the national average say $1200.If they invest the whole amount in p2p loans they get $108 interest per annum .However the risk rate is nearly (100-9)=91% of the income .To buy a new house they could instead invest in fixed deposits for 3 years as the compounding effect of FD (fixed deposits) will neutralise the lower interest dillema of household 2.


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