Among investors, peer to peer lending has become the most popular investment option compared to bonds and savings accounts.
Peer to peer lending allows investors to lend unsecured personal loans to borrowers and earn annual returns at the interest rate of 7%, 9% or sometimes even 11%. Not bad for making a profit. But you should also be aware of the fact that this type of investment can be risky. So get your facts straight before you commit your money to peer to peer lending.
How P2P loans/ investment works?
Peer to peer lending is non-bank banking. Similar to regular banks, p2p is making loans and returns the profit from those loans to the lenders/investors. However, what p2p differs in is that it removes the ‘middle man. A middleman is usually a banker. Instead of investing money in certificates of deposit and funds through a bank, you can invest directly in the P2P loans that the borrowers have taken out on the peer-to-peer lending platform.
So, what happens is that borrowers come to the p2p lending sites and fill out an application. The application requires just basic information such as loan amount and the loan purpose, along with a typical credit evaluation. The information is then made available to the lenders on the platform, who can pick the loans they wish to invest in.
High Return Rates
Most p2p lenders report yearly returns of more than 10%. This is not surprising; usually, interest rates on loans offered by the peer-to-peer platform ranges between 6% and 36%. However, a high-interest rate means riskier investment.
Create a Diversified Investment Portfolio
On p2p lending platforms, you get control over your investments compared to other types of investments. You can choose the loans based on their loan type, loan term, interest rate, legal charge etc. This way you can manage your individual investments. Some p2p companies have an auto-invest process that does all this for you—making investment tension free.
But if you want less risk, then lend to those who are less likely to default. Keep in mind the interest rate will be lower.
** Note that the interest rate you see on a peer to peer lending website is not guaranteed. Rather, it’s a ‘target’ or ‘projected’ return, so you may earn fewer returns.
Does peer to peer investors have to pay tax?
The returns that you earn through peer-to-peer lending are classed as income, which means you have to pay tax. But, thanks to your personal savings allowance, a basic rate taxpayer can get up to £1,000 of tax-free interest annually, and a high-rate taxpayer can get up to £500 annually.
If you wish to earn tax-free interest, then put your money in Innovative Finance ISA, and you will not be taxed on your earned interest. All you have to do is just invest within your £20,000 per tax year.
Benefits and drawbacks of peer to peer loans
- It is cheaper than the bank
- No early repayment fee if you want to repay the loan earlier than the end of term
- You will be paying a fee to the p2p provider for arranging the loan
- You need a good credit score
- You might not be able to make monthly repayments.
Limit your investment
Since there is a risk of borrower default, it would be better to limit your investment in peer to peer lending to a small percentage. For instance, if you keep 25% of your investment portfolio in fixed-income, then you can put a percentage from that into p2p lending to increase your return without taking a lot of risks.
Try the Art of Re-investing
P2p investment is self-amortizing which means you have to be diligent about re-investing your returns. If you do not re-invest, then your returns will decline as the loan pays down. The idea is that you should always stay invested by investing in new loans.
If you believe peer to peer lending is for increasing the fixed income part of your investment portfolio, then it will serve your investing needs well. However, just like other risky investments, it can never be seen as an all-fund investment to dominate your portfolio.
* The information on this page is not advice. Always ask financial experts for advice if you aren’t sure about your investment choices.