What is peer-to-peer (P2P) lending?
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.
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.
How does peer-to-peer lending work?
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.
Our short video explains how peer-to-peer lending works.
Is peer-to-peer lending safe?
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 small chunks 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.
Some platforms 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.
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.
Peer-to-peer lending: FAQ
Does peer-to-peer lending show up on your credit report?
So far, we've explained how peer-to-peer lending works from an investors perspective. But if you want to take a loan through a peer-to-peer lender, it was similarly to a traditional loan.
When you apply for a loan with a peer-to-peer lender, your credit report will be checked. A 'hard' credit check will be recorded, and will remain on your credit report for 12 months.
As with all credit applications, this could temporarily reduce your credit score. And if you're rejected for a peer-to-peer loan, try not to make too many credit applications over a short period.
This reflects badly in the eyes of financial companies, as it looks as though you're struggling to borrow successfully.
How do peer-to-peer lending companies make money?
Each peer-to-peer lender is different. Some charge fees to both investors and borrowers, while others charge fees to only borrowers.
RateSetter, for example, charges an administration fee and a credit rate fee for borrowers, which depend on how much you want to borrow, the repayment term and your personal credit score.
Zopa charges loan servicing fees to borrowers, and a fee if you want to sell a loan and cash out your money as an investor.
What is peer-to-peer business lending?
It's not only personal customers who can take a loan from a peer-to-peer lender - many websites offer loans to businesses, too. Some only offer loans to businesses.
For investors, lending to businesses tends to pay the highest rates of return. That's because they come with the biggest risk of default, so interest rates are higher to compensate you for taking that additional risk.
Some sites allow you to choose options that are lower risk, or have a mix of borrowers with different risk levels. The latter pays a higher rate of return, but will have a higher 'bad debt' rate - which means more business will fail to pay back what you've lent them.
At the racier end, there are business peer-to-peer lenders that offer annual rates of return in the double digits but proceed with caution here. These are likely to be lending to companies that are very high risk, and have had trouble borrowing from traditional sources.
What happens if a peer-to-peer lender goes bust?
Here's the important part. Unlike traditional savings accounts, peer-to-peer lending is not protected under the Financial Services Compensation Scheme, which protects the first £85,000 of your savings should the company holding them go bust.
However, if the website that introduced to a borrower, who you ultimately lent you, became insolvent, you would still have that relationship, so in theory you would eventually get your money back from a borrower.
Any money that sits in an account with a peer-to-peer lender that hasn't been lent out is usually ring-fenced from the website and held with a different bank that is protected under the Financial Services Compensation Scheme.