Peer to Peer lending has increased in popularity in recent years. Today we are going to find out about the risks and rewards associated with these types of investments.
What is Peer to Peer lending?
Peer to peer lending is when people willing to lend money come into contact with people looking to borrow money on a website. Peer to peer lending cuts out the banks and as there is no middleman both lenders and borrowers obtain better rates.
Some Peer to Peer lending sites allow you to choose which individuals you lend to. Other Peer to Peer do not give you a choice and instead, your money is automatically lent to lots of borrowers. This reduces your risk as you are spreading the risk of a borrower defaulting on the loan.
Who are the main Peer to Peer lending sites?
The most popular Peer to Peer platform in the UK is Ratesetter. It launched in 2010 and to date, they have matched over £3 billion lenders to almost 600,000 borrowers.
Ratesetter was the first Peer to Peer lending site to launch a Provision Fund to protect investors. No individual investor has yet lost a penny through Ratesetter. This makes it a reasonable choice if you are risk-averse.
Zopa is the UK’s oldest peer-to-peer lender having started in 2005. Since then it has lent more than £4 billion to over half a million borrowers and generated a £250m in interest for the lenders.
Funding Circle was the first website to use peer to peer lending for business funding in the UK. Funding Circle has lent more than £7 billion to almost 70,000 businesses. It currently operates in the UK, Germany, US, and the Netherlands. The company is listed on the London Stock Exchange.
How safe is Peer to Peer lending?
The biggest risk affecting peer to peer lending sites is that you do not get your original capital back. This could happen because the site runs into financial difficulties. Alternatively, the person you loaned the money to may not be able to repay the debt.
Peer to Peer lending sites are investments and because of this, they are not covered by the Financial Services Compensation Scheme. As a result, if anything goes wrong your investment is at risk.
The Financial Conduct Authority does require the P2P sites to have a plan in place should they encounter difficulties. This alleviates the risk to a certain extent as the borrower repayments should continue. However, any P2P site failing would certainly cause issues that may potentially result in losses being incurred by investors.
What protection is in place?
Ratesetter has a Provision Fund to protect lenders and most of the other big Peer to Peer sites have similar funds. However, if a large number of people defaulted on their loans it is possible that these emergency funds would be insufficient. This could result in you losing some or all of your money.
Despite its size Funding Circle does not have a protection fund. According to Funding Circle, the best way to protect your money is by spreading it as widely as possible over different loans to minimise your risk if one borrower fails to repay.
Smaller P2P sites offer less protection and although some offer emergency funds not all do. Those that do tend to have restrictions in place meaning if things do go pear shaped you are more likely to lose your money.
Can P2P lending be done tax efficiently?
Interest earned through peer to peer lending is classed as income in the UK and is therefore taxable. However, in the UK each individual has a Personal Savings Allowance which for basic rate taxpayers is £1,000. Higher rate taxpayers have a reduced Personal Savings Allowance of £500.
A basic rate taxpayer would not pay any tax on their income from Peer to Peer lending if they received less than £1,000 from Peer to Peer lending and this was their only source of income that fell within their Personal Savings Allowance.
Innovative Finance Isa’s (IFISA) were introduced in 2016. An IFISA is much more attractive as it allows someone to invest up to £20,000 in Peer to Peer lending if they so wish. Ratesetter, Zopa and Funding Circle all offer IFISA.
In the tax year 2019/2020 an individual can invest up to £20,000 tax free in an ISA. This can be split between a Cash ISA, a Stocks and Shares ISA and an Innovative Finance ISA.
When should I invest in Peer to Peer Lending?
You should only invest in Peer to Peer sites once you are aware of the risks and have carefully read all the information on your investment as the risks vary from site to site.
If you have any loans or debts you should repay these first as the interest rate you are borrowing the money is likely to exceed your investment returns. Similarly, make sure you have sufficient cash in your emergency fund just in case things do go wrong.
Also, be aware that some P2P sites require you to tie your money up for longer periods. If you need your money back quickly you may be better putting your money into a traditional savings account.
What returns do P2P lending sites generate?
The rates of returns paid to lenders in P2P sites varies from site to site. The rates can also vary from minute to minute depending on the supply and demand for money. In general, the rates offered by P2P sites are much higher than traditional bank deposit accounts.
At the time of writing Ratesetter was offering a return of 3.4% on the Rolling Market. The return on its 1-year investment product was 3.9% and the return on its 5-year product was 5.1%.
Zopa meanwhile offered 4.5% on Zopa Core and 5.2% on Zopa Plus. The Plus product lends more to people with limited credit history who are believed to carry a higher risk of default.
Funding Circle offered rates of 4.3% to 4.7% with their Conservative Option and rates of 4.5% to 6.5% with their Balanced Option. The Conservative Option lends to creditworthy businesses with lower estimated bad debt risks. The Balanced Option also lends to creditworthy businesses but these are estimated to have a higher bad debt risk.
As you can see the rates offered by different Peer to Peer platforms vary according to the level of risk an investor is willing to take. All three of the above Peer to Peer lending sites beat the best instant access savings rate found on Moneysupermarket. That was 1.47% offered by Sainsbury’s Bank.
According to Prudential the average return on UK stock market investments over the 25 year period to 2014 was 5.2%. This beats the rates offered by Ratesetter, Zopa Core and Funding Circle’s Conservative Option. Zopa Plus draws with this return. Funding Circle’s Balanced Option potentially beats this return but this rate would be lowered by any bad debts.
Overall, whilst Peer to Peer lending yields a better return than traditional savings. The jury is still out on whether they can beat the returns offered by the stock market. However, P2P lending can offer decent returns if you are prepared to accept the risks and therefore is certainly worth considering as an investment.