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.
Peer-to-peer lending takes the concept of lending money to family and friends and expands it on an industrial scale, with Peer-to-Peer 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 the key is that they will have gone through rigorous checks to ensure they can pay back the cash.
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 depending on the level of risk they want to take.
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 be 'ringfenced' before it's lent out – that is, it'll be kept separate from the Peer-to-Peer 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, however there is no guarantee that this will cover all, or any losses incurred. Providers must explain how their contingency fund works, and what it covers.
From a lender's perspective, the system is essentially like 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 may even be able to access their money at any time, subject to charges.
Despite Peer-to-Peer 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.
The Financial Conduct Authority has identified that Peer-to-Peer lending is higher risk than other savings and has brought in some rules to protect retail investors. Unless you declare to the Peer-to-Peer company that you are a high net worth, or sophisticated, investor, you will need to go through an assessment to show that you understand how a Peer-to-Peer arrangement works, and that it is an appropriate method of saving for you. This will cover a range of things such as your relationship with borrowers, the variable and non-guaranteed nature of the arrangement and any risks involved, among other things.
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.
Where a Peer-to-Peer arrangement has a target return for savers, the Peer-to-Peer firm must have processes behind the scenes to maximise the chances of the target return being achieved.
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.
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.