A guide to peer-to-peer lending

Income-seeking investors have been drawn to peer-to-peer lending on account of the attractive returns on offer. Here’s everything you need to know about this growing sector

The Bank of England may have nudged the base rate up to 0.75% – its highest level in almost a decade – but this rise hasn’t been passed on to most savers.

Three quarters of banks and building societies have failed to pass the rate rise on to customers, with the average easy-access savings account offering a pitiful interest rate of just 0.52%, according to MoneyFacts.

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Almost a decade of low interest rates has caused many income-seekers to veer away from traditional savings accounts. With a number of peer-to-peer (P2P) platforms offering returns above 10%, savers have been abandoning their traditional cash savings accounts in favour of P2P.

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P2P has gone from a quirky financial outsider to a billion-pound industry, winning approval from financial watchdog the Financial Conduct Authority (FCA) and the government. What is more, Innovative Finance Isas (IF Isas) allow savers to enjoy tax-free returns on their P2P investments.

So what exactly is P2P and how can you get in on the action?

Some P2P firms let you choose exactly which firms to lend cash to

P2P: the basics

The idea is pretty straightforward: you lend your money to individuals or businesses using a P2P platform as the middleman. Interest rates on loans are still considerably higher than the returns available on savings accounts. For example, the recent base rate rise was swiftly passed on to borrowers, so you can enjoy a better interest rate as a lender.

Because you are cutting the banks out of the deal, P2P is good for both borrowers and lenders. The person borrowing money gets a lower interest rate than they would from a traditional lender and the person lending the money is offered a higher interest rate than they would receive from a traditional savings account.

Some of the best-known P2P platforms are Funding Circle, LendingCrowd, Lending Works, RateSetter and Zopa. Expect returns of between 3% and 7% a year, depending on which account you choose.

P2P platforms operate in different ways: some require you to spread your money across numerous loans, while others allow you to choose exactly which firms to lend money to.

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For example, Zopa offers two types of account: Zopa Core, which aims to return 4% a year, and the riskier Zopa Plus, which targets an annual return of 4.6%. After you select an account, Zopa will spread your money across a number of suitable loans. This means you will not have a say in the loans that are selected for your portfolio.

Alternatively, LendingCrowd allows you to choose which businesses to lend to, with interest rates ranging from 5.95% to 14.25% a year.

Depending on the length of the loan, it can prove difficult to access your money once you have invested in P2P. The best way to do this would be to sell your loan on to another investor. Some platforms allow you to do this via a ‘secondary market’, but there may be fees and charges involved.

Avoid the banks

The prospect of cutting out the banks attracted David Ivison, 55, a teacher from East Sussex, to P2P lending.

“Back in 2007 I required a loan, so approached my bank of 25 years and was given a loan offer with what I considered to be a very high interest rate. It seemed that loyal customers are just another group to be exploited, so dissatisfaction with the traditional financial institutions was a big factor in my interest in peer to peer,” he explains.

David has been investing with Funding Circle since 2012 and has gradually built up his P2P loan portfolio.

“With Funding Circle, I like the thought that I am lending (almost) directly to small businesses which need the money and want to bypass the banks. It gives me a feeling that I am really involved in helping them. Most are very small and have maybe been refused by a bank.

“Of course, I have to trust that Funding Circle can correctly assess the loan, but, so far, I am happy to say that it has my trust,” he explains.

Get tax-free returns

Back in April 2016, P2P got a boost when the IF Isa launched, allowing savers to generate returns on their P2P investments tax-free. Individuals can invest part or all of their £20,000 Isa allowance into an IF Isa during this tax year.

However, it has taken a while for the IF Isa to gain traction. This is because P2P platforms required FCA approval before they were able to launch these products, and this took a surprisingly long time – up to a year in some cases. In the end, some of the lesser-known names managed to get through the red tape first.

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During the 2017/18 tax year, investors subscribed to 31,000 IF Isas, up from 5,000 the previous tax year. While this represents a significant increase, it pales in comparison to subscriptions of 7.8 million in Cash Isas and 2.8 million in Stocks and Shares Isas.

However, it is worth noting that individuals who subscribed to an IF Isa invested relatively large sums. The average IF Isa attracted £9,355 during the 2017/18 tax year, which compares to £5,114 for a Cash Isa and £10,124 for a Stocks and Shares Isa.

Today, close to 85 companies are authorised to offer IF Isas – including Zopa, RateSetter, Funding Circle and Lending Works – and the number of people opening accounts is expected to steadily increase.

The lure of attractive returns

The prospect of higher returns in comparison to traditional savings accounts attracted Hazel Johnson*, 60, a university professor from north London to P2P investing. She has invested with RateSetter for several years.

“I had received an inheritance and put this aside in ‘protected accounts’ [Isas and savings accounts] funds that were needed for my children’s education and other essentials. So I only used P2P for funds that were at the very limit I could lose, but the aim was clearly to get a better return than was offered by typical lenders.

“I also read widely to get a sense of which P2P company seemed the most reliable and had self-regulated protections in place to deal with bad loans, so I went for a calculated risk.”

Hazel also took steps herself to keep the risk to a minimum.

“I put funds in the rolling fund [easy withdrawals] to keep control and when there was some publicity in the press about a bad commercial loan that RateSetter had made, I removed some funds.

“I am not so flush that I could take more than calculated risks. However, when it became clear that this bad loan had resulted in no loss to individual investors, I reinvested funds into RateSetter,” she says.

“I like helping small firms that maybe a bank has turned down”

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Beware of the risks

When it comes to P2P, remember the first rule of investing: the prospect of higher returns may mean that you are taking on more risk. It is not the same as putting your money in a savings account at a bank.

Despite the fact that several comparison websites including GoCompare and LoveMoney list P2P alongside savings products on best-buy tables, your cash is at risk and you may get back less than you put in.

By lending your money out to individuals or businesses, you run the risk of a borrower defaulting on their repayments and leaving you out of pocket.

It’s also worth noting that P2P platforms are not covered by the Financial Services Compensation Scheme. This means that if the platform goes bust, you could lose your money.

Understandably, you may presume that opting for a P2P platform that offers the highest interest rates means you are taking on the most risk. However, this isn’t necessarily the case. Every platform assesses risk differently – so if a P2P lender offers a lower interest rate, it may not mean that you are taking on less risk.

The P2P market has been going strong for the past 10 years, which has been a period of relative stability for financial markets. The sector is yet to experience a downturn, in which a large number of borrowers default on their loans. A financial crash could also increase the amount of time it takes you to sell your loans on the secondary market if you want to get your money out.

“P2P has not yet been through a full normal market cycle, so we have not experienced the impact of high interest rates, high inflation and high default levels on the market,” says Danny Cox, chartered financial planner at investment platform Hargreaves Lansdown.

“The interest cost of a P2P loan is actually quite small. It is the repayment of the capital that is the problem. This means the business lending P2P market will be sorely tested when businesses start to flounder or fail in a recession, and on the personal lending side when unemployment rises,” he adds.

In the past, many P2P platforms tried to mitigate the risks associated with lending by having safeguard or provision funds in place. These acted as a safety net to cover losses in the event that one of your borrowers defaulted on their loan. However, it is not clear how these funds would cope in a financial crash, as they don’t hold enough money to cover the platform’s entire loan book.

What is more, several big P2P platforms don’t have provision funds at all. For example, Zopa started phasing its out last year, while Funding Circle doesn’t have one in place.

“We don’t believe the provision fund model is the best way to provide investors with stable returns. Instead, diversification and transparency are the best way for investors to manage risk effectively,” says Kendra Bruckner, a communications executive at Funding Circle.

It is essential to ensure diversification across your P2P portfolio.

Neil Faulkner, founder of 4thWay, a peer-to-peer lending ratings agency, notes that spreading your money across at least half a dozen P2P platforms and many hundreds of loans can “tremendously lower your risks”.

“Lenders should not allow themselves to believe they can accurately select a small number of loans to outperform,” he adds.

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Moneywise verdict

P2P investing offers a lifeline to savers looking for a better return than those on offer from traditional savings accounts.

But be aware of the fact you are investing: this is higher risk than simply keeping your money in a savings account. Take steps to keep that risk down by diversifying your P2P portfolio, making sure only a fraction of your savings are in P2P and keeping some money in a traditional savings account for emergencies. Also, make sure you are comfortable with the fact your investments could go down in value.

Comparing P2P platforms can be complicated, so Moneywise recommends that beginners stick with a mainstream provider until they gain more experience in the sector. After some time, they may wish to invest via a specialist platform that provides control over where the loans are allocated.

Our top picks are highlighted above – Zopa, RateSetter, Lending Works and Funding Circle. They all scored highly at the Moneywise Customer Service Awards 2018, with Zopa named the Most Trusted P2P Provider and Lending Works taking the award for the Best P2P Platform for Investors, with Funding Circle, RateSetter and more property-focused Assetz Capital and Lendy also shortlisted.

Where to invest – the big players

Zopa

This is the longest-running P2P platform in the UK, having launched back in 2005. It has lent £3.5 billion since it began, with more than 60,000 lenders and more than 300,000 borrowers on its books.

Choose between Zopa Core, which aims to return 4% a year, and Zopa Plus which targets an annual return of 4.6% (after fees and bad debts). You have to invest at least £1,000 and Zopa will split your money into £10 chunks that are lent to different borrowers. There is a 1% charge if you want to access your money early.

Zopa also offers an IF Isa with the same Core or Plus options and projected returns of 4% or 4.6% respectively.

RateSetter

RateSetter has lent more than £2.7 billion since its launch in 2010 and has close to 68,000 lenders and 499,000 borrowers registered on its website.

You can choose between three different accounts, depending on how long you wish to tie your money up for. The first option is to open an account offering access to RateSetter’s ‘rolling market’, which allows you to access your money whenever you like free of charge. This account targeted an annual return of 3.1% at the time of writing.

The next option is RateSetter’s one-year account, which had a projected return of 4.3% at the time of writing, while the five-year account targeted 5.6% a year. With the latter two, you’ll pay 0.3% or 1.5% respectively for early access.

RateSetter has a provision fund, which totals £34.3 million and is used to provide a buffer against credit losses. If you use this platform, you will be offered a set rate at the time you invest that you should receive. So far, RateSetter’s customers have received the rate they signed up for.

There is also an IF Isa option with the same three accounts to choose from.

Funding Circle

Funding Circle is another big player with £3.8 billion lent. It has 39,000 businesses and 75,000 lenders on its books, including the government-backed British Business Bank which has provided more than £100 million for small business loans.

The platform offers two accounts: Balanced, where your money is lent across the risk spectrum, and Conservative, which only lends to the two lowest-risk classes. Balanced has a projected return of 6% to 7% and Conservative aims for 5% to 5.5%.

You can no longer choose which companies you lend to with Funding Circle. The firm now uses an ‘auto-bid’ system, which means your money is spread across a large number of borrowers to minimise the risk of a bad debt making a significant dent in your returns. No more than 0.5% of your money will be lent to a single business.

Your money is lent over a six-month to five-year period. If you want to access it before the loan matures, you’ll need to trade it on the secondary market.

Funding Circle also offers an IF Isa with the same Balanced and Conservative options.

Lending Works

This P2P platform specialises in personal loans and works in a similar way to RateSetter – your account choice will be determined by how long you want to lend money for. You can either opt for a three-year option earning 4.5% a year or a five-year account at 6% a year.

If you want to access your money early, you’ll pay a 0.6% fee and will only be able to do so if other investors are available to take over your loans.

Lending Works also has a ‘shield’ to protect your money from missed loan repayments and defaults. This is made up of an insurance scheme and a reserve fund.

As with the other platforms, your money will be spread across numerous loans to protect you from one bad loan wiping out your capital. A nice thing with Lending Works is there is plenty of data on its website to show you how much is being lent, who is borrowing and how the Shield has protected lenders over the past five years.

Lending Works also offers an IF Isa with the same rates as its standard P2P offering.

Reduce your risk

Investing in P2P comes with more risk than keeping your money in a traditional savings account. But, as with all investments, there are sensible steps you can take to lower the risks.

1. Spread your money between providers – Investing your money with several P2P platforms means that if one firm goes bust you won’t lose all your cash.
2. Make sure you pick a varied portfolio of loans if you plan to choose them yourself – for example, don’t just invest in property loans.
3. Only put some of your savings into P2P – make sure that you’re not investing money that you can’t afford to lose.

*Name changed for privacy.

Ruth Jackson is a freelance personal finance journalist who writes regularly for Moneywise,The Times and MoneyWeek