A guide to peer-to-peer lending

Most of us are interested in finding ways to improve our financial situation, and the evolution of the financial services sector in the last few years has created a variety of new models serving both investors and borrowers. One of the most interesting developments has been the growth in popularity of peer-to-peer lending, usually known as P2P. 

For investors, the attraction of P2P lending is that it can offer substantially better returns than traditional forms of investment. The Bank of England may have eased the base interest rate up to 0.75%, but historically speaking, this is a very low level, and many banks and building societies have failed to pass the rise on, which means that investors are often looking at interest rates of around 0.5% if they opt for traditional models. 

In this environment, it is not hard to see why investors will be looking elsewhere, to companies such as Lendy, a P2P finance company that offers users the opportunity to invest in property or to borrow money through P2P sources. What exactly is P2P lending, and how does it work?

The basics of P2P

The basic principle of P2P lending is simple. You lend money to individuals or businesses directly, with the P2P platform acting as the middleman. Different P2P platforms work in different ways. Some will enable you to choose which firms or organisations you lend money to, while others will spread your investment across a range of loans. 

Cutting out the banks

One of the biggest appeals of P2P lending is the fact that it cuts out the traditional financial industry entirely. Confidence in the traditional finance industry has taken a hit in recent years, and this has led many people to seek alternatives. By bypassing the banks and building societies, P2P lending offers benefits for both lenders and borrowers. Typically, those who borrow money through a P2P platform will benefit from a lower interest rate than they would find with a traditional bank or building society, while investors will enjoy a higher interest rate on the money they invest. 

Tax-free returns

The fledgling P2P finance industry received a significant stimulus in the spring of 2016, with the launch of the Innovative Finance ISA or IF ISA. This new ISA made it possible for investors to benefit from tax-free returns on their P2P investments, with an annual IF ISA allowance of £20,000. 

The IF ISA has proven to be a slow burner, mainly because P2P platforms that wanted to offer the ISA had to gain approval from the Financial Conduct Authority (FCA), and this proved to be a long process in many cases. However, the number of investors opting for an IF ISA increased from 5,000 in the 2016-17 tax year to 31,000 in 2017-18, and now there are more than 85 P2P platforms that are authorised to offer IF ISAs, with the typical investment being over £9,000. 

Higher returns

The key attraction of P2P lending is the prospect of better returns than through traditional banks. There are, of course, no guarantees with P2P lending, and as with any form of investment, there are risks, which we will discuss in the next section. However, because of the way that they operate, P2P platforms generally offer the prospect of a significantly higher return than with traditional financial institutions, and the intense competition in this sector has led to the development of new tools, such as the “rolling fund” option that gives investors more control over their investments. 

Risks of P2P

As with any financial investment, there are risks associated with P2P lending. Although it offers the potential of higher returns than a bank savings account, it is not the same type of investment and comes with significantly higher risk. There is the risk of a borrower defaulting, which will leave you unable to reclaim your investment, and as P2P platforms are not part of the Financial Services Compensation Scheme, if they go out of business, then their investors are not protected. 

This is why it’s important for P2P lenders to first do their research and only invest with the platforms that have the best reputations and that most closely fit their needs. As with other forms of investment, such as stocks and shares, by spreading your investments across several P2P operators, you will be diversifying your risk and minimising the danger of losing your money. 

Conclusion

For those who understand the risks, and who do their homework, P2P lending offers an innovative and potentially profitable alternative to savings accounts. By cutting out the traditional banking system, this innovative approach to lending and borrowing offers a dynamic and modern way for informed investors to boost their savings.