Peer-to-peer lending explained
By Michael Trudeau
Article 1 of 5
Peer-to-peer lending explained
If you're looking into investing, you may have come across peer-to-peer lending. Here, we explain what it actually is, how it works and if it could be an attractive investing option for you.
With interest rates on savings accounts and cash Isas struggling to beat inflation, many savers are thinking about putting their money into riskier investments that offer a better rate of return. Peer-to-peer lending sites have some similarities to saving with banks, but the risks are higher. Each site works differently and some have started offering safeguards to lower the risk of losing money. So is it worth it?
What is peer-to-peer lending?
Peer-to-peer lending sites match up savers, who are willing to lend, with borrowers - either individuals or small businesses.
Rates can be better than those offered by banks, but high rates come with added risk, most notably the fact you might struggle to get your money back if the borrowers you've lent your money to fail to repay. Peer-to-peer sites aren't covered by the Financial Services Compensation Scheme (FSCS) which guarantees your savings with banks and building societies up to the value of £85,000.
Peer-to-peer lending sites rated
Which? members have rated the UK’s three biggest peer-to-peer lending sites - RateSetter, Zopa and Funding Circle. Find out the pros and cons of each in our reviews:
Peer-to-peer lending: the risks
By cutting out the middleman and not having the overheads of traditional banks, peer-to-peer sites can often offer you more favourable rates, whether you're a lender or a borrower who has struggled to get a personal loan elsewhere.
By being connected directly to someone who wants to borrow, the most immediate risk to your capital is if a borrower fails to repay what you have lent them (known as defaulting).
Sites manage this risk in different ways. Zopa and RateSetter offer compensation funds which should automatically cover you if a borrower defaults. However, these compensation funds are not infinite. It's possible that in a crash where lots of borrowers default at the same time, they could run out of money, although it hasn't happened so far. Funding Circle takes a different approach: there's no compensation fund, but there are higher returns on offer.
Peer-to-peer sites – what to watch out for
If you're a lender, there are a few things you need to watch out for when using peer-to-peer lending sites:
- RateSetter and Zopa show the rates of return you can expect after they've deducted their fee. On Funding Circle, the rates you see usually don't include their 1% annual fee.
- You'll need to weigh up the risk of losing some or all of your money. The risk is likely to be lower if there's a compensation fund.
- Some peer-to-peer lending sites will allow you to withdraw funds early if you wish to, although there will be a fee.
- Returns on peer-to-peer lending are currently taxable as income. You'll need to tell HMRC how much interest you earn at the end of the year.
- However, a new type of Isa called the 'Innovative Finance Isa' was introduced from 6 April 2016 for peer-to-peer lending. You are able to set up your Isa with an individual platform so that any interest paid by borrowers is tax-free. The government is also consulting on whether to extend this to equity and debt crowdfunding.
If you're a borrower, not only will you be credit-checked by a credit reference agency, you'll also have to pass the peer-to-peer site's own credit-worthiness tests in order to qualify for a loan.
Peer-to-peer lending and Isas
In 2014, the coalition government announced its intention to allow peer-to-peer investment Isas. If held in an innovative finance Isa (Ifisa), peer-to-peer loans would fill part of your stocks and shares Isa allowance, meaning that you would be able to invest your annual Isa allowance through peer-to-peer lending without paying tax.
However, only a handful of companies have secured the necessary regulatory permissions to offer Ifisas.
Other peer-to-peer lending sites
Funding Circle, RateSetter and Zopa are the three biggest peer-to-peer lending sites in the UK, and founding members of the Peer-to-Peer Finance Association - a trade body which has set out operating standards that formed the basis of the move towards formal regulation by the Financial Conduct Authority in April 2014.
However, many other peer-to-peer lending sites have emerged. These include:
- Lending Works
- Madiston LendLoanInvest
- Wellesley & Co
- Last updated: March 2017
- Updated by: Michael Trudeau