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Peer-to-peer lending – how it works

Category: Loans
Author: Tim Leonard
Updated: 09/03/2018

Peer-to-peer lending (or P2P lending) is essentially a hybrid form of saving and investing that can offer much bigger returns than traditional methods, and it's quickly becoming a popular choice for investors who want more than traditional savings accounts can offer them.

However, although the potential of earning higher returns on your money can be tempting, it isn't for everyone. This guide will take you through the peer-to-peer lending process so you can decide if it's the right option for you.

What is peer-to-peer lending?

Peer-to-peer lending takes the concept of lending money to family and friends and expands it on an industrial scale, with P2P websites being designed to unite lenders with borrowers for mutual benefit.

The lenders are typically savers looking for a decent return on their money and the borrowers are individuals or companies looking for a cash injection, but key is that they will have gone through rigorous checks to ensure they can pay back the cash.

How it works

The lender will put their savings/investment into an account for it to be loaned out to borrowers, and in return will receive a decent interest rate – usually pre-set, and in some cases it can even be chosen by the lender themselves.

Lenders can also often choose the type of borrower they want to lend to – perhaps someone who's been given an excellent credit rating, a good one or a fair one – with different interest rates being available depending on the level of risk (interest rates will often be higher if you lend to a 'riskier' borrower, for example).

They'll then decide on the amount to be loaned out and the repayment terms, and the P2P site will allocate the amount accordingly. Often they'll split the investment up into separate loans to spread the risk between individuals, reducing the possibility of the lender not getting their money back.

The investment will usually be 'ringfenced' before it's lent out – that is, it'll be kept separate from the P2P company's finances – offering an additional financial safeguard should the company itself go bust. Some even have their own bailout funds to reimburse lenders should borrowers not repay the money.

From a lender's perspective the system is essentially similar to a traditional savings account – they'll put their money in for a set amount of time, will receive interest on their investment, and will get their capital back once the term has come to an end. They can even access their money at any time, subject to charges.

Advantages of P2P lending

  • You could earn up to double the usual savings rates.
  • Borrowers are rigorously credit checked and often only a small percentage of applicants are accepted.
  • If borrowers don't repay the loan, most P2P sites have facilities to chase repayments and even reimburse lenders.
  • Easy access to money subject to fees.
  • P2P lenders are regulated by the Financial Conduct Authority, offering the same kind of protection as with more mainstream finance providers.
  • You can reduce the tax you owe by investing in a P2P site via a new type of ISA called an Innovative Funding ISA. All your interest will be tax-free.

Disadvantages of P2P lending

  • Unlike normal savings, your money isn't protected by the Government's guarantee (the Financial Services Compensation Scheme, which from January 2017 protects up to £85,000 of savings per person per banking licence), meaning your savings could be lost if something goes wrong.
  • You'll be charged fees, although these will be reflected in the rate of interest.
  • You still have to pay tax on the money received outside an ISA. From April 2016, the first £1,000 of interest earned on savings is tax-free for a basic rate taxpayer (£500 for a higher rate taxpayer and nil for an additional rate taxpayer). This also applies to interest on a P2P loan, so you need to work out your returns based on your taxpayer status and other interest received.
  • It's a higher-risk form of saving than traditional methods.

Understand the risks

Despite P2P companies being designed to be as low-risk as possible, it's still a much riskier form of saving than a regular savings account. It's important for investors to go into it with their eyes open – despite the prospect of good returns, there's also the possibility of losing your money, with little legal recourse to bail you out.

Beware of the 'unknown unknowns'

Peer-to-peer lending is still a relatively new market with an innovative model that hasn't been tested over the long term, so there could still be unexpected issues that could crop up at any time. Investors are therefore advised to not put all their assets into the P2P model and instead spread them between different types of savings and providers so as not to be over-exposed.

Disclaimer: This is a basic guide to peer-to-peer lending and does not cover every circumstance. The information it contains is correct as of April 2017. Some of the information may become inaccurate over time, for example because of changes to the law.

Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.