What is peer-to-peer lending?
Peer-to-peer websites (P2P) act as introducers between borrowers looking for credit and savers or investors looking for better returns on their deposits. By sidestepping the banks in the middle, this enables peer-to-peer sites to offer better terms for both parties.
This will be of particular interest to savers, who have seen the rates on traditional savings accounts plummet since the onset of the financial crisis.
How does peer-to-peer lending work?
Peer-to-peer websites keep a tight control on where savers’ funds are invested by undertaking stringent credit checks on all borrowers. Once a borrower is accepted, their case is profiled by risk, which determines the interest rates they will be charged.
Savers have plenty of options available to them. They can choose how much they want to lend, who they wish to lend to, and how long to lend for.
Most peer-to-peer platforms allow savers to automatically spread their funds across a range of borrowers and risk profiles to create a mid-range return. Some sites have decided to simplify this by offering a fixed-rate bond, which reflects these mid-range conditions.
Some sites allow savers to customise their investments, so you can opt for higher risk options with high-return, or lower-risk options with lower returns.
Savers will still be taxed at the normal rate on any interest they earn from peer-to-peer investments, though the Government has held a consultation about how to bring peer-to-peer funds inside the ISA bracket.
What are the risks involved?
The main risk with peer-to-peer lending is that funds are not protected by the Financial Services Compensation Scheme (FSCS) in the same way that standard deposits are.
The FSCS protects consumers by insuring the first £85,000 per person per financial institution if a bank goes bust. Peer-to-peer funds are not protected in this way, which makes this a risk venture.
However, peer-to-peer websites do have mechanisms in place to alleviate risk. Some sites will spread investors’ money across many different borrowers to reduce the impact of a default upon any one investor. Some will allow savers to select a below-average risk profile. And most sites now have a fund in place to absorb a percentage of any losses.
If a peer-to-peer site goes bust, lending agreements should still theoretically remain in place, but it could become a trickier process to ensure that repayments are maintained.
Is peer-to-peer lending regulated?
The sector is regulated by the Financial Conduct Authority. So, if peer-to-peer sites wish to become legitimate, they must follow a set of safety standards and have contingency plans in place in case anything goes wrong.
The regulator also ensures that firms do not hoodwink less experienced investors by downplaying the risks. It’s imperative that savers know the risks before they put forward their cash.
If you’re disillusioned with the rates you are receiving on your savings, it may be worth considering whether you’re prepared to take a leap of faith into a relatively new industry to see if you can get the kind of returns that you’re looking for.