Peer to peer lending has been used for investment in the UK for the past 15 years. This type of investment is meant to remove the middleman between the borrowers and the savers by providing them with a platform where you can borrow and lend money directly. But, the most important question, is a peer to peer lending safe? How much can you make using P2P and what are the risks? Before we dive into the risks of peer to peer lending let’s quickly review the basics.
What is peer to peer (p2p) lending?
With P2P lending, you can lend money to people who need to borrow money, without going to a bank. This is a direct approach where lenders can earn a high interest rate, and borrowers can pay a low-interest rate. This is possible because peer to peer companies have fewer overheads compared to a bank.
But, peer to peer does not completely remove the middleman. Peer to peer platforms does a lot of the complex work like vetting the borrowers, getting repayments for lenders and handling all the transactions. For this, the peer to peer platforms takes a cut from the profit you earn.
Generally, there is a better financial outcome for both the borrowers and the lenders. However, there is a higher risk for lenders compared to the risks of a bank account.
How P2P lending works?
There is a lot of peer to peer platforms available. As a lender, you just have to register with the platform of your choice and pay using a direct transfer or debit card. You will agree to the offered interest rate and the period you would be lending money for. Once the loan is repaid with interest at the end of the term, you can take out the money or re-invest your returns to grow your funds.
Some platforms allow you to choose the borrower you would like to lend your funds to. But, commonly platforms split your funds between different borrowers to manage the risk for you.
Is peer to peer lending safe?
Peer to peer lending is called ‘investing in loans’ as well. Like other types of investment, securing a profit from a peer to peer loan includes financial risk.
In the UK, each peer to peer platform is regulated by the Financial Conduct Authority (FCA). This law protects investors from malpractice by p2p platforms. But, this still does not protect you from loss or provider insolvency.
Unlike building societies or banks, peer to peer isn’t covered by the Financial Services Compensation Scheme (FSCS). It means that if the provider goes out of business you could lose all your money altogether you may get some money through the process of liquidation.
Likewise, if the funds you have loaned are not repaid, you aren’t protected by the UK government and you might lose money. Most of the well-known peer to peer companies have a reserve fund set up which protects lenders’ money even if the borrower fails to repay the money. But these reserve funds are not bottomless and in extreme cases, they may be exhausted. In such circumstances, you may first lose out on your expected returns and ultimately lose the whole investment. The chances of this happening are not high but there still is a possibility.
Risk of Defaulting Borrowers
The biggest risk of peer to peer is the defaulting borrowers. But most well-known platforms plan for such an outcome. The major peer to peer lending companies is transparent by giving every borrower a risk rating or factoring ‘bad debt’ into your predicted return. Usually, with higher interest rates there is a greater financial risk associated.
How much should you invest in P2P lending?
Peer to peer lending doesn’t require any hefty commitment. You can begin investing with as little as £10, with no maximum limit. However, the FCA has set a limit for the beginners of peer to peer lending to protect them against default. According to this rule, new investors can only invest 10% of their assets into a peer to peer lending company. They can invest more if they get independent financial advice.
Advantages of P2P lending
For people who can afford to take a risk, peer to peer lending can produce a good amount of return and it doesn’t even need much effort, since the peer to peer companies do most of the administrative work and debt-chasing.
In addition, funds that you earn through peer to peer companies are generally classed as income. This means it is taxable, even though the majority of lenders don’t pay tax thanks to their personal annual savings allowance. With the annual allowance, a basic rate taxpayer can earn up to £1,000 tax-free interest each year or £500 for high rate taxpayers.
All peer to peer lending platforms have to be regulated by the FCA, so they must comply with the FCA regulations. If you want to become a peer to peer investor then make sure to have a diversified portfolio, to manage the risk. Remember to invest according to your budget and risk appetite.
* The information on this page is not advice. Always ask financial experts for advice if you aren’t sure about your investment choices.