Lending using a Peer-to-Peer website

Peer-to-peer (P2P) lending websites allow investors (lenders) to find borrowers and vice versa, matching them up in order to give more profit to the lender, and lower rates to the borrower. This is achieved by taking banks and building societies out of the equation, and the wedge of interest they normally earn. That's not to say that the peer-to-peer websites don't take a cut, but when compared with the banks, it is typically less.

However, there's a catch for those who invest with a Peer-to-Peer website – you could lose money, and because of the nature of your investment, you wouldn't be covered under the terms of the Financial Services Compensation Scheme (FSCS) if the Peer-to-Peer provider goes bust. So, read on for Moneyfacts.co.uk's guide to lending through a Peer-to-Peer website…

It's true to say that when you deposit your savings with a bank or building society they use some of your money to lend out to other customers.

However, with P2P lending, there is a fundamental difference in where the risk lies.

In summary:

• Savings account – their risk, less reward
• Peer-to-Peer – your risk, greater reward.

Because you are taking the risk of losing money, the comparison with a savings account is not useful – in fact it can muddy the water.

Therefore, you should view peer-to-peer lending as making an investment instead.

The Peer-to-Peer market is now regulated by the FCA, although not in the same way as banks and building societies. The FCA has studied the market, and while they acknowledge that Peer-to-Peer is a legitimate alternative to savings, they have put in place mare safeguards to protect customers. Peer-to-Peer lenders must provide "fair, clear and not misleading" information for consumers to help them understand the higher level of risk involved and make better financial decisions.

Some key points under the FCA regulations that give users a little more security are:

• Peer-to-Peer lenders must keep client funds separate from their own money. This means that any funds or repayments are held in a third-party account.
• Peer-to-Peer lenders must have reasonable steps in place to manage the repayments and collections in the event of a firm collapsing.
• Peer-to-Peer lenders must hold a set level of capital to withstand any financial shocks in the future. This does not include having a mandatory safeguard fund to further protect savers.
• Borrowers that have a change of heart and do not wish to continue with the loan have a 14-day period to change their mind and cancel the loan agreement.
• The FCA introduced rules on 9th December 2019 to give investors the right to complain, first to the firm and then, if relevant, to the Financial Ombudsman Service.

The FCA also is concerned that customers do not understand Peer-to-Peer arrangements sufficiently well and has introduced some new requirements on providers.

Unless you confirm in writing 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 loan 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.

It is advisable to spread your money between lots of different borrowers – you can usually do this in chunks of as little as £10 – to limit your exposure to the risk of default. Some Peer-to-Peer providers automatically split your investment between tens or even hundreds of borrowers to reduce the risk. However, in the unfortunate event that a borrower defaults, you could lose your money. Many Peer-to-Peer sites have set up their own ways of protecting their investors, but you must remember that this is not the same as the protection offered by the FSCS and does not guarantee to pay out in the event of default.

The Peer-to-Peer lending website makes money from both you and the borrower. You will have to pay a fee (normally either an initial fee that's a percentage of the amount you lend, or a percentage of the amount of interest you receive). The borrower will also usually pay a fee for their loan.

If you are allowed to access your money before the end of a loan term, you may also have to pay a percentage of the cash you've lent.

Interest earned on a Peer-to-Peer loan is treated the same way as interest on a regular savings plan. Up to the first £1,000 of interest in any tax year is now tax-free under the Personal Savings Allowance (PSA), and P2P loan interest counts towards this. The interest will be paid gross, and if you earn over your annual PSA in interest, you will need to disclose this to HM Revenue & Customs to settle any tax you need to pay.

Since April 2016, Peer-to-Peer loans can also be held as individual savings accounts (ISAs). These are called Innovative Finance ISAs and you can use your entire year's ISA allowance for these ISAs.

That's the great thing about Peer-to-Peer lending – you decide. This doesn't mean you get to go round to their houses for a cup of tea and assess their ability to pay, but rather that you can specify the "type" of borrower you lend to.

Categories range in order of risk, with A* being the lowest risk borrower type. The higher the risk of borrower, the higher the rate you can charge, but bear in mind that higher risk means just that – more chance of you losing your money.

Some Peer-to-Peer websites allow you to find out what the borrower needs the money for, but you need to be careful with this more personal approach, as it could cloud your judgement to the financial merits of lending to one borrower over another.

In general Peer-to-Peer lending is not suitable for money that you know you're going to need access to quickly. You should look at Peer-to-Peer lending as an investment activity, where your money could be tied up for a few years at a time. This is not to say that you can't access your funds. Some Peer-to-Peer websites offer short term alternatives, however this comes at a price – you would earn more interest if you can commit your money for longer but remember that you then won't have access for the full term.