What on earth is peer-to-peer lending?

What on earth is peer-to-peer lending?

For savers and pensioners, there’s no getting away from the fact that things have been pretty grim over the last decade. Interest rates plummeted after the recession, before being cut to new record lows in the wake of the Brexit vote last year. Banks have inevitably followed suit by offering derisory returns on savings accounts and cash ISAs, and with news that inflation is set to soar to three per cent by April, it’s pretty clear that earning real returns is going to become increasingly challenging.

No wonder then that many people are seeking alternatives, and one that has proven to be particularly popular has been that of peer-to-peer lending, which involves investors lending their money directly to borrowers via an online platform. These platforms effectively facilitate a transaction which involves no intermediary (for example, banks or building societies), thus ensuring both lender and borrower benefit from this direct efficiency.

The platform’s job is to vet borrowers based on creditworthiness, and to ensure that everything functions smoothly for the duration of the lending term. For this, they take a small fee.

How competitive is this as an investment?

First and foremost, returns tend to be in the region of 4 to 5 per cent, depending on the platform, and the period for which you are willing to lend for. This is clearly well above the levels one can expect within other mainstream savings channels. Further up the risk spectrum, better returns can obviously be achieved in asset classes such as stocks and shares, albeit with no guarantees. As such, it’s fair to say that peer-to-peer lending is something of a midpoint between savings and stocks & shares in terms of earning potential. But how does it compare in terms of risk?

Safety of peer-to-peer lending

The important think to note with peer-to-peer lending is that capital is at risk, and if a borrower defaults, or if the platform goes under, there is no cover from the Financial Services Compensation Scheme. That said, platforms generally have measures in place to counter this. Most have third-party agreements to wind down loan agreements in the event of the company going bust.

More importantly, it is also now industry standard to have a segregated fund – topped up by a portion of fees paid by borrowers – to cover any arrears and defaults. Some platforms even take this a step further with an additional insurance to cover lenders losses for typical borrower default reasons; including accident, illness, death, and even fraud or cybercrime.

As such, although not guaranteed, returns have historically been very stable and predictable.

Regulation and ISAs

The other element of reassurance is that peer-to-peer lending is now regulated by the FCA, which means platforms face many obligations in terms of compliance when it comes to things like their processes and systems, thus meaning only those which are fit for purpose will remain operational.

An additional feather in the cap is that platforms which are fully authorised by the FCA are entitled to apply for ISA Manager approval from HMRC, and, if granted, can provide a new type of ISA known as the Innovative Finance ISA. This means that lenders can effectively shield returns from tax through this wrapper, which inevitably makes it even more lucrative as an investment.

Making your decision

Any kind of investment is a very personal decision, and what is most important is that you are comfortable with the level of risk you are taking on versus the level of reward on offer. In this respect, it is understandable why peer-to-peer lending continues to grow in popularity. That said, it remains a young asset class, and it is thus important that you do your research, so that if the time comes to put your hard-earned money into it, you are fully informed when doing so.