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Peer-to-peer investing

Peer-to-peer lending explained

By Michael Trudeau

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Peer-to-peer lending explained

Peer to peer lending matches up people looking to invest their money with people who want to borrow it, paying higher interest to savers and lower rates for borrowers. Find out how it works. 

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 is similar to saving with a bank, but pays much higher rates of interest. But unlike a traditional savings account, you can lose money. 

So is it worth it? This guide explains how peer-to-peer lending works, the risks of doing it and what you need to watch out for if you want to take the plunge. 

What is peer-to-peer (P2P) lending?

Peer-to-peer lending sites match up savers, who are willing to lend, with borrowers - either individuals or small businesses. 

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.

You invest through a website, but lenders work in different ways. Some allow you to choose who to lend to, while others spread your investment out on your behalf. 

Borrowers are credit-checked by a credit reference agency, and also have to pass a peer-to-peer site's own credit-worthiness tests in order to qualify for a loan. Some lenders allow you to choose the credit-worthiness of a borrower - choosing a riskier person often results in higher rates. 

The sites also take care of collecting money from borrowers.

Peer-to-peer (P2P) lending  sites rated

Which? members have rated four of the UK’s most popular peer-to-peer lending sites - RateSetter, Zopa, Funding Circle, and Wellesley & Co. Find out the pros and cons of each in our reviews:

Peer-to-peer (P2P) lending: the risks

By being connected directly to someone who wants to borrow, the most immediate risk to your money is if a borrower fails to repay what you've lent them (known as 'defaulting').

Sites manage this risk in different ways. Zopa, for example, splits your investment into £10 chunks, to be spread out across multiple loans. This helps spread risk, and means that if one borrower fails to repay, your whole investment doesn't take a hit. 

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. 

Most importantly, 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 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.

Will I pay tax on peer-to-peer lending profits?

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 tax year.

However, interest earned on peer-to-peer lending falls under the Personal Savings Allowance. That means basic-rate (20%) taxpayers can earn £1,000 a year in interest tax-free, while higher-rate taxpayers can earn £500 a year without paying any tax. 

A new type of Isa called the 'Innovative Finance Isa' was introduced on 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.

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:

  • Landbay
  • Lending Works
  • LendInvest
  • Madiston LendLoanInvest
  • MarketInvoice
  • ThinCats
  • Wellesley & Co
  • Last updated: July 2017
  • Updated by: Michael Trudeau
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