Everyone seems to be talking about peer-to-peer lending these days. Also known as P2P lending, this is where money is loaned to businesses (or individuals) online, using systems that match lenders with borrowers. For businesses, it can prove to be an easier way to raise much-needed finance. For investors, it can provide a return on your money. But these accounts are not risk-free, despite the fact they are often positioned as being similar to a high-interest savings account. In this article, we explore peer-to-peer lending to give you the facts.
How does it work?
Since the financial crisis, it has been much harder for businesses to access finance. As a result, peer-to-peer lending exploded onto the financial scene. As the name suggests, at its core is the idea that investors lend their money to a business that needs it, and charges those businesses interest. The peer-to-peer lending accounts available online do two key things. Firstly, they set interest rates for each company that wants a loan, according to its likelihood of keeping up repayments. Secondly, they structure the accounts such that each investor is lending their money to hundreds of companies.
The biggest peer-to-peer lenders are Funding Circle, Zopa and Ratesetter.
What are the risks?
Despite the fact that these accounts are often advertised to look rather like savings accounts, they’re not. The possible return on your money is much higher than in a savings account, which tells you one thing: there’s much more risk involved.
Peer-to-peer lending is generally high-risk, typically providing unsecured loans to small or unproven businesses which can’t get funding from the banks. There is no guarantee that money will ever be repaid, which is a big risk for investors. Peer-to-peer online services are also not covered by the government-backed Financial Services Compensation Scheme, which protects savings of up to £85,000 (and other forms of investment too). Some lenders promise to protect investors’ money themselves and have a pool of money set aside for that purpose. But that promise is only as strong as the company, and the size of that pool.
Recently, two of the largest peer-to-peer lenders – Ratesetter and Zopa – have come under fire. Ratesetter was forced to reconcile a £9m loan that went wrong and has intervened in failing wholesale loans to protect its investors. Zopa investors have faced a dramatic cut in expected returns. The peer-to-peer market is facing a lot of questions, which means you need to be fully aware of what you’re getting yourself into. However, this industry is being developed, so things may improve in the future.
Questions to ask
There are now a vast number of peer-to-peer lending services available – some are more reputable and secure than others. Always fully research the online service you are considering and ask them these questions:
1. Are you tied in for a period of time, or can you get your money back on demand?
2. What happens if the loans fail?
3. What level of cash reserves does the lending service have to remedy any problems?
4. Do you have visibility of where your money is going?
5. What is the maximum potential loss you could face?
Understanding the alternatives
If you’re looking to get a better return on your money, we would always look at a diversified investment portfolio. Whereas peer-to-peer lending accounts are completely focussed on loans (which are known as bonds in the investment world), a diversified portfolio will have a mixture of different types of investment. That includes bonds with large businesses and governments, stocks and shares, and property. Spreading your risk between different types of investment means that your money is more likely to do better in the long-term.
In short, peer-to-peer lending accounts are certainly not suitable for everyone but could be an ingredient in a wider investment portfolio.
If your interest in peer-to-peer lending is the fact that you can directly help smaller businesses, perhaps consider investing through crowdfunding. It’s a topic for another blog, but this route at least enables you to choose the businesses you want to support, read their business plans and really get involved in their future. Just be aware that some ventures will be successful and you’ll make a return on your money, but others will certainly fail and your investment can be lost.
If you’re looking at ways of improving the returns on your money, it is always worth speaking to a professional financial planner, who will review your situation and provide sound advice aligned with your objectives. There may be various savings and investment strategies that you have not considered.