Peer-to-Peer Lending In The UK: What You Need To Know
Many people new to investing are looking to alternative finance products and passive investments as ways in which they can be more creative with their investment to make better returns.
Of course, profit on an investment can very rarely be guaranteed and also is very rarely without an element of risk, but increasingly there are financial platforms out there which are designed to bring together like-minded people, as a way to reduce risk by enabling an investor to select the type of product they invest in.
Peer-to-peer lending is one such platform, as it puts people wanting to lend money together with businesses or individuals who want to borrow money.
What is peer-to-peer lending?
Often called P2P lending or crowd lending, this is a platform in the form of a website or app, which manages a transaction between a lender (you) and a borrower (an individual or business). You have money that you want to lend/invest, and the platform partners you with a borrower who will use your money and then pay it back, with interest on top.
In most cases, both parties are looking for a favourable outcome, in that you want a bigger interest rate on the money you lend and receive back than you would normally get from a bank or building society, whilst the borrower is looking for a loan they can repay on a lower interest rate than a regular business or personal loan from a financial institution.
This is normally possible for both parties because the P2P lending platform acts as the go-between and there are no fees or overheads to be paid to a bank or building society.
P2P lending products are also attractive to the borrower because they can generally get their hands on money quicker and easier than through regular financial products, and as such this is a common means of financing property developments, for example, where the P2P loan effectively acts as bridging or mezzanine finance.
How does P2P lending work?
There are various platforms which manage P2P lending and offer different products and packages, so you need to carry out some thorough research and perhaps take some independent financial advice, to find the package that suits you best.
You can usually open an account with the website and deposit either a lump sum or set a fixed monthly amount to invest for a fixed period.
The P2P platform runs credit checks on its borrowers and builds a financial profile on them. This is then used to help them pair you with suitable borrowers.
You may be offered a more attractive rate of interest, say 6.5% rather than 4 or 5%, if you agree to lend your money to a specific borrower that may have a higher level of risk, or require your capital to be tied up for longer. Likewise, you may be able to secure a lower rate of interest on an investment that is deemed less risky, or requires locking away your capital for a shorter period of time.
With some platforms you are able to split your investment and lend to multiple borrowers. This will lessen your risk in the case that one borrower doesn’t pay your money back. You can usually limit how much you lend to one single borrower, such as a percentage of your total investment, if you have concerns over a specific borrower or investment opportunity.
Otherwise, you can often set up automatic parameters which manage your investment and restrict how much you lend to one borrower, and this can also ensure that your investment is only selected for loans at a minimum interest rate. You may need to change this if you are finding that no borrower is willing to accept the loan on an interest rate you are insisting on.
Some platforms will enable you to negotiate with a borrower over the terms of the loan, or you may prefer to be a passive investor and leave the automated system to arrange everything for you.
Your loan can be repaid monthly with interest or on an annual basis.
You will be charged a fee – usually about 1% - for an early withdrawal of your cash. This is to cover the platform having to find a new investor to take on your loan.
You will also be charged a transaction fee for the loan itself. There are other fees involved in the transaction, such as commission for the platform, but these are usually shared with the borrower. In all cases you can research these fees before you proceed and ensure that you are happy with the arrangements offered by the platform in question.
What are the benefits of P2P lending for investors?
Potential for higher returns than a savings account
Fundamentally, lenders are seeking to get better returns on their investments than they would through putting similar cash amounts into savings accounts in a bank or building society. This is possible because you are dealing with a ‘middle man’ directly and not paying costs to banks or building societies.
The interest rates offered by the P2P lending platform will vary according to the creditworthiness of the applicant borrower, and so this allows the investor to mitigate their potential losses. In other words, you can invest according to the amount of risk you are prepared to accept.
Investment is managed by the platform
If a borrower fails to repay your loan, the peer-to-peer lending platform does all the chasing on your behalf. You are a passive investor, and while you still run the risk of not recovering your investment, you will not lose time or resources fighting to recover it.
Investments can be tax efficient, in certain circumstances
Whilst your income through P2P lending is taxable and must be declared annually to HMRC, the rules relating to P2P lending mean you have a personal savings allowance of £1000, which can be used to offset this. So you will only pay tax on interest earned above £1000. This is applicable to basic rate taxpayers (20%), whilst for higher rate taxpayers (40%) the personal allowance is £500.
You do have the option on some platforms of holding your P2P loan in an Innovative Finance ISA (IFISA), which means you can lend up to £20,000 per tax year – the annual limit for all types of ISA – and not pay tax on the interest.
How is P2P lending regulated in the UK?
In general terms, all P2P lending platforms must be regulated by the Financial Conduct Authority (FCA). The biggest benefit of this for lenders is that it ensures all investors’ money is ring-fenced in a separate account for security. It also dictates that all P2P lending organisations must present information clearly and be transparent and honest about the inherent risks of peer-to-peer lending.
From 9<sup>th</sup> December 2019, FCA regulations also stipulated that new investors in P2P lending platforms could only invest a maximum of 10% of their investable assets, this is to ensure that inexperienced investors are not over-exposing themselves to possible risk.
The regulations state that investors with two or more investments in two years on the platform are not restricted by this same stipulation, however, it is a strategy which could be followed by any investor with any level of experience, merely as a sensible measure.
The 36H membership group was formed as a self-regulatory body by a collective of P2P lending platforms. This acts as a ‘voice of the industry’ and is authorised by the FCA as it follows the Article 36H of the Financial Services & Markets Act 2000.
Tighter FCA regulations also now dictate that P2P lending platforms are required to hold a £50,000 stock of buffer capital funds, to insure themselves against financial uncertainty, this should be used to compensate investors in the event of loans via the platform not being repaid.
However, unlike banks and building societies, P2P lending platforms in the UK **are not covered **by the Financial Services Compensation Scheme. Savings up to £85,000 can be guaranteed with banks and building societies, but this level of protection is not available with P2P lending.
What are the risks of investing in P2P lending?
Capital at risk
The most obvious risk of P2P lending is that the money you invest – which is leant to a borrower – may not be paid back, or it may be paid back late. This is known as a default. Most P2P lending platforms have a ‘default rating’ which is an up-to-date measure of how the borrowers on their platform perform in terms of repaying their loans.
Of course it is in the platform’s own interest to have that rating as low as possible. Some platforms have contingency funds to repay investors in the event of a default on payment, but it could be a risk for the investor to heavily rely on this, particularly if the borrower has defaulted as part of a bigger market crash for example. This could be difficult for the platform to recover from, so each individual case is different.
Repayments being made early or late
A loan made on a P2P lending platform can be paid back early or late, and in either case you could miss out on interest and therefore this reduces your profits. You do have the option of re-investing this cash of course, but it is possible you won’t receive as attractive an interest rate.
P2P lending is a fast moving industry
P2P lending is a relatively new industry and therefore many platforms are fledgling businesses that are sensitive to any market volatility. If the platform goes out of business, you may lose your investment completely. As peer-to-peer lending is a new sector, there is an ‘unknown’ as to how it will react to economic downturns or any financial uncertainty, such as Brexit.
P2P lending should be viewed as investing, not saving, and comes with risks
P2P lending is not a saving scheme, it is an investment scheme, and hence there is no guarantee that you will make any income from your investment, and indeed you could end up losing money.
P2P lending is a low liquidity investment
If you want to pull your money out of a scheme early, this is possible, but of course your borrower most likely still needs the money, or is not in a position yet to pay it back. Therefore there can be a delay in you receiving your money when you want to withdraw, as the platform has to find a new investor. In addition to this, the terms of your loan may bar you from withdrawing early comletely, locking in your capital until an agreed upon date.
Past performance does not guarantee future returns
The historical performance of a P2P lending platform may not necessarily be a reliable guide as to the suitability of your investment. The platform is likely to use many borrowers and offer a number of different products, so you can only judge an investment on the specific data presented, ie. the product terms and the credit rating and financial profile of the borrower(s), you can’t be guided too much by the platform as a whole.
Should I invest in a P2P lending platform?
As with many financial investments, you should measure the size of your investment against the inherent risk associated with it, and make the decision from there. How much are you prepared to lose?
Within the P2P lending sector there are packages to suit everyone’s attitude to risk, and you should take independent financial advice in order to establish which one suits you best.
Certainly this, associated with suitable and adequate research into individual investment proposals, means that you are able to manage your cash sensibly with P2P lending and enjoy some more lucrative returns if you view this as an investment rather than a saving scheme.
When considered as a ‘passive’ investment scheme, P2P lending is perhaps one where you do need to be vigilant and carry out some extensive research, whilst also monitoring your returns a little more actively. You may need to be ready to withdraw your money when the time is right, but this kind of diligent management, tied with thorough research, can make P2P lending an investment worth looking at.