If you lend money and the borrower defaults on their loan, what happens next?

The answer to that is going to depend on what kind of loan it was in the first place, principally whether it was secured or unsecured.

What’s the difference? In a nutshell, a secured loan has some kind of asset or guarantee that acts as collateral in case the borrower is unable to make the payments as scheduled. The asset – which might be a house, or a car – is then used to pay back the borrower.

If you have a mortgage on your house, then you will be familiar with secured lending. If you default on payments, eventually the bank or mortgage provider will repossess the house to get back the value of their loan.

By contrast, unsecured loans are not linked to any particular asset that provides security for the lender. These loans generally come with a higher interest rate to reflect the additional risk, and require strong credit history on the part of the borrower.

Does that mean you’ve lost all your money if you lend to an unsecured borrower and they default? Not necessarily, but it’s usually harder to recoup the value of your loan, and you may end up with only a proportion of what you were owed.

Let’s use the example of a loan to a small business. In the event of a company going into liquidation, debts are usually paid off according to a hierarchy, with ‘senior’ creditors – often with secured debt – reimbursed first through funds raised via a sale of assets the company has at the time of liquidation. After senior debt and costs have been met, ‘junior’ creditors (often the peer-to-peer lenders in the case of a P2P loan) will get a proportion of what remains, which will normally be only a certain percentage of their initial loan value.

What does it mean for peer-to-peer lending?

If you’re thinking of investing in peer-to-peer lending, it’s important to understand the difference between secured and unsecured lending, and what that means for your potential return.

Some P2P platforms offer really high rates of return, with target rates in excess of 10%. Often this will be because the loans are unsecured, and therefore much riskier for the creditor in the case of default.

By contrast, a product like Octopus Choice invests in secured loans: in our case, ones held against property. The rate of return may be lower, but so too is the risk of you losing your money compared to an unsecured peer-to-peer lender.

So, for those who are considering a P2P investment, remember that it’s never just as simple as comparing one interest rate against another – unsecured lending is an entirely different ball game to secured lending. Instead, you should be looking at the nature of the loans you’d be investing in, and make sure it fits with the risk-reward profile you’re comfortable with.

You can take a look at Octopus Choice’s lending criteria here.

Remember, Octopus Choice places your capital at risk – you may not get back the full amount you put in. Also, peer-to-peer investments are not protected by the Financial Services Compensation Scheme (FSCS). Money invested through Octopus Choice is concentrated in property and could be affected by market conditions. For the same reason, instant access cannot be guaranteed.