Crowdfunding platforms

Crowdfunding platforms and their usage are becoming increasingly more common, but are the actually a good investment idea?

What is crowdfunding?

Crowdfunding is a platform by which lenders and borrowers are linked together. Lenders tends to be people like you and me. Borrowers tend to be small businesses who for whatever reason are unable or don't wish to borrow money from a bank. The platform directly connects lenders with borrowers without the need for a bank. 

Generally borrowers are graded by the crowdfunding platform according to level of risk assessed within the business. Lenders can choose to target different levels of returns based on the level of risk associated with the borrower. Obviously the higher the risk then the higher the return.

Normally, the crowdfunding platform will charge a fee for using their platform. This commission is normally about 1 percentage point of the interest. For example, if the interest on your loan is 8% then the crowdfunding platform will take 1% leaving you with a net 7% remaining. Do not be confused into thinking that the 1% is charged on the total return! The actual commission is a lot bigger (in this case it's 1%/8% = 12.5%).

Benefits and drawbacks to crowdfunding

The result of crowdfunding tends to mean that the rate that the lenders (I.e savers like you and me) tend to earn are higher than those returns from putting your money in a bank. Conversely, your money is being lent directly to businesses. As such, business are able to borrow the money that they need for expansion/working capital/ investment. Given that some businesses could go bankrupt then it is possible to lose all of the money that you lent to the Company. As such, saving via crowdfunding is riskier than putting your money in a bank. I will point out however that crowdfunding platforms will attempt to get as much of your money back as possible following the business going into liquidation.

Reducing your risk

It is possible to reduce the level of your risk exposure on a crowdfunding platform by diversifying your portfolio.

Instead of lending out £1,000 to one lender at 8% you could spread your risk by lending £100 to ten different borrowers at an average of 8% each. It is less likely that all ten of the borrowers would go bust and as such you've reduced your risk. If you're going to get involved in crowdfunding then you should look to build a portfolio of micro loans rather than lend to one or two borrowers.

Portfolio analysis

If you're thinking of getting involved in crowdfunding and want to know whether you should or not think about it this way. Never invest in one thing. You should always try to build a portfolio of assets rather than just invest in property/stocks/bonds. Likewise with crowdfunding it is not unreasonable to have a portion of your savings tied into crowdfunding in order to obtain a bigger return. However, it should be another part of your portfolio of assets and not your main focus.

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