Peer to peer lending: What you need to know
In recent years, the peer to peer (P2P) lending market has grown rapidly. As you’ve looked for ways to maximise your savings, you might have come across opportunities and may even have been tempted. But, whilst it’s a sector that’s growing fast, it’s crucial to understand what it means and the associated risks.
With interest rates still low following the 2008 financial crisis, savers are looking for a home for their money that offers returns. With potential interest rates significantly higher than what you can find at high street banks, P2P lending can certainly seem attractive. However, as with all financial decisions, it’s essential that you understand what P2P lending involves and the risks.
What is peer to peer lending?
P2P lending is a relatively new asset class that started gaining traction in the last decade or so. It offers a way for people to lend money to individuals or businesses via a loan that interest is paid on. As a P2P investor, you’re effectively acting as a lender.
Most commonly, P2P lending is conducted through marketplace style platforms that connect lenders with borrowers. There are numerous platform options to choose from and they don’t all operate in the same way. However, there are two main ways to get involved with P2P lending through a platform:
- A managed option will pool your money with other lenders’ assets, which will then be used to provide loans to a range of businesses and individuals. This can help diversify your investment to spread risk and you can take a more hands-off approach if you prefer. Some platforms will only offer a default managed option, whilst others may provide you with a choice with varying risk levels.
- Alternatively, you can manually select which potential borrowers you’d like to offer money to. This route allows you more flexibility in building a portfolio that suits you. However, you’ll need to take responsibility for assessing the level of risk and be more involved during the whole process.
Returns from P2P lending are derived from the interest paid on the loans. As a result, they vary significantly, typically ranging from 4% to 20%. Compared to interest rates on savings accounts, these potential returns may be attractive. However, the risk is greater and, typically, the higher the potential return the more risk you’ll be taking on.
What are the risks?
Receiving a return on P2P loans is entirely dependent on the borrower’s ability to continue to meet repayments. Should they be unable to pay and default on the loan, you may not get back the amount you put in. There’s also a risk that repayments will be late. As a result, P2P lending is considered riskier than alternative options, such as investing through stock markets.
As with investing, there are P2P opportunities with various levels of risk. Those offering lower interest rates will generally be considered lower risk when compared to those offering higher rates. Where the borrower is offering high-interest rates in comparison to loans or credit cards available on the high street, it’s beneficial to consider why this is. It could suggest they have a poor credit history, for instance.
Again, as with investing, it’s important to consider how risk is spread with P2P lending and avoid putting all your eggs in one basket.
It’s also worth noting that P2P lending is not covered by the Financial Services Compensation Scheme (FSCS). If a borrower defaults on a loan or the platform used ceases trading, the FSCS will not help you recoup losses.
What’s the secondary market like?
A key consideration before plunging into P2P lending is the possibility to sell the loans you hold. There is a secondary market for P2P lending, however, it’s relatively small and limited. It can be incredibly difficult to sell loans and you may find there’s little market for it. As a result, you should consider P2P lending an illiquid asset.
How important the secondary market for P2P lending is will depend on your personal circumstances. Let’s say you loan a sum for a 36-month period, is there a chance you’ll need access to that money before three years are up? If the answer is ‘yes’ you should carefully explore what your options would be if you needed to sell the loan and look at alternatives.
What are the tax implications?
The returns generated through P2P lending are considered income. Therefore, profits may be liable for tax if you exceed your Personal Savings Allowance (up to £1,000).
If you’re interested in P2P lending and are likely to pay Income Tax on the returns, one option to consider is an Innovative Finance ISA (Individual Savings Account). ISAs offer a tax-efficient way to save and invest, with the Innovative Finance ISA designed specifically for P2P lending. Returns generated through an Innovative Finance ISA are tax-free. Each tax year you have an ISA allowance of £20,000, this can be spread across several different types of ISA or deposited in just one.
Is it an option for you?
For most people, P2P lending isn’t the most appropriate option for growing their money. P2P lending should be considered a high-risk asset, which will not be suitable for the majority of investors. The potential returns on offer can be tempting but it’s important to weigh this up with the likelihood of a borrower defaulting on their loan.
If you’d like to discuss P2P lending in the context of your personal circumstances, please get in touch. We’ll identify whether it’s an option that suits your financial circumstances and aspirations, as well as exploring other options.
Please note: As an investor, your capital may be at risk and you may not receive back all the money you invested should a business not be able to fully repay its loan. Your money is not protected by the Financial Services Compensation Scheme. Past performance is not a reliable indicator for future results.
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