Peer-To-Peer Lending: An Alternative Way To Generate Bank-Beating Interest Rates From Your Savings

10 mins

Peer-To-Peer Lending: An Alternative Way To Generate Bank-Beating Interest Rates From Your Savings

Introduction To Peer-To-Peer

Do you ever look at a bank and think “I could do that”? Stash a bit of money under your mattress, give it out to friends when they need it… because y’know how hard can it be? As with everything in life, it’s not that simple. But thanks to the world of peer-to-peer lending, you can indulge in that fantasy and start performing some of the same functions.

How does it work?

The concept of peer-to-peer (or P2P) lending is pretty straightforward. It’s when ordinary people like you or me lend money to others – either individuals in need of a bit of cash or small businesses looking to grow. It’s all done through online platforms that match up borrowers and lenders, kind of like online dating. P2P lending cuts out the middleman (the bank) which means higher returns for investors and lower interest rates for borrowers. In theory, it’s a win-win. However, repeat after me, nothing is ever that simple.

What’s in it for me?

As an investor, P2P lending offers decent interest rates – around 6% a year is feasible. That’s considerably more than if your money was simply sat in your savings account. Plus it can also offer tax benefits (in the UK, for instance, you can invest via an ISA). It’s an attractive prospect for people fed up with the low-interest world of savings accounts.

But those benefits come with risks, of course (they always do!). The money in your savings account is pretty safe – the bank is extremely unlikely to go bust, and your money is often protected by the government as a last resort. That is not the case with P2P lending. Your money is given to individuals and small businesses, and the likelihood of them defaulting (i.e. not paying you back) and you losing your investment is not negligible.

Why do borrowers use P2P lending?

Basically, it’s about cost and convenience. Borrowing rates are often lower than those from traditional lenders, it can be faster to get the cash, and generally applications are done entirely online. Plus P2P companies sometimes use different credit scoring models to banks, so if a bank doesn’t accept you for a loan you might still have a shot with P2P.

In this pack we’ll give you an overview of P2P lending: explaining how it works, what the risks are, and how you can mitigate them. Next, we’ll look at the risks...

The Risks Of P2P Lending

Different P2P platforms serve different markets. Some lend to small businesses, some fund property developments, some offer loans for car purchases, some lend to individuals without securing the loan on an asset – and some lend to a combination of all of those.

They all have different risk profiles. For example, loans secured against an asset (like a car or a house) are generally considered less risky than unsecured loans. But some risks are common across all segments.

Give me the gory details. Firstly, P2P lending is illiquid (i.e. once your money’s lent, you can’t demand it back, and it will typically be locked away for a fixed term). Some platforms have a “secondary market” where you can sell your loans to other people – but don’t rely on someone buying your portfolio. Assume the money you’re lending is gone until the repayment date.

That’s assuming you ever are repaid, of course. It is likely that some of the loans will default, as the borrower just won’t be able to afford it. That’s totally normal. Your losses should be outweighed by the interest you’re paid on other loans so (in theory) you end up making money, not losing it. However, there’s no guarantee. There’s a chance every single one of your borrowers could default, and if they’re unsecured loans you could be left with nothing. That might sound far-fetched based on P2P companies’ track records (they tend to have tolerable default rates), but things could change during an economic downturn. Remember the 2008 recession? Back then, banks were hit by mass defaults. In the next recession, it could be you losing your cash instead…

How can I mitigate these risks?

Diversify, diversify, diversify! Don’t put all your eggs in one basket: spreading your investments reduces the chances of your entire portfolio defaulting. Some platforms also let you set a risk level you’re comfortable with, allowing you to opt-out of lending to high-risk borrowers. That will mean accepting lower returns, however.

Next, we’ll give you some tips for how to pick the right platform for you.

Picking Your Platform

We’ll walk you through how to decide on a P2P platform. There’s a lot to take into account, but here are some of the most important questions to think about.

What loans do they offer?

It’s important you understand what you’re signing up for. Is the platform loaning to individuals or businesses? Are those loans secured on any assets? And if they have a mix of loans on offer, what’s the split in their portfolio? Like we said before, different loans have different risk levels, so this is hugely important.

How much will it cost me?

Some platforms charge fees to lenders (Funding Circle charges 1%, for example) – you’re going to want to be aware of those and how they might affect your returns.

What’s the quoted returns rate?

Sometimes the interest rate publicized by the P2P platform takes into account the possibility of some borrowers defaulting, other times it doesn’t. What were default rates for similar borrowers in the past? Are the platform’s estimated default rates reasonable?

Is there a provision fund?

Some platforms have a fund designed to repay you in the event of missed payments or a default, others don’t. But be aware that even if they do have such a fund, there’s no guarantee you’ll be repaid. If there are too many defaults, the fund could run out of money to repay lenders.

Can you choose your risk level?

Some platforms allow you to pick a level of risk you’re comfortable with, spreading your investment over a portfolio of loans in your chosen risk category. That’s potentially helpful if you’re more risk-averse but can result in lower returns.

Is the lending diversified by default, or do you get to pick borrowers?

It depends. Some platforms take a lump sum from you and lend it out to a whole bunch of borrowers. Others let you pick individual borrowers, so you can assemble your own portfolio. The latter is probably riskier – you’ve got to have a lot of confidence in your own ability to assess borrowers.

Do they lend to literally anyone?

Before you invest, see if you can find out how the platform accepts borrowers. Do they automatically turn away anyone too risky, or do they let them in anyway? You want to know if your idea of risk correlates with the platform’s idea, too.

Are they regulated?

Some countries have regulations for P2P platforms that require them to take steps to protect lenders in the event that the platform goes bust. However, don’t blindly place your trust in regulations. Your money might be gone forever even if the government technically has your back. There are also trade bodies that impose rules on their members – you’ll probably want to go with a platform that’s in one.

Next up, we’ll look at how to pick borrowers yourself, if that’s what you end up doing.

Assessing A Borrower

Deciding who to lend to is hard. Multibillion-dollar companies exist just to determine whether someone is worth the risk of lending to (hello, Equifax and Experian!) so be warned it’ll be pretty tricky to figure this out yourself. However, if you do want to go down this route, here are some things to consider.

Are you diversified?

Remember when we were considering P2P lending risks and we emphasised the importance of diversifying your portfolio…? Diversifying is even more important when you’re the one picking the borrowers. Lending all your money to just one borrower is very risky. The chances of you losing everything skyrocket, as only one thing needs to go wrong for your entire portfolio to be rendered worthless. The effort might be larger but putting small amounts of money in lots of different loans is much more sensible.

Is the loan secured?

Some loans will be secured against an asset like a house or a car. That makes losing your money less likely.

Unsecured loans don’t have the same safety net. If they’re business loans however they might come with a “personal guarantee” from the business directors, who are then on the hook to pay you back with their own money even if the business can’t.

What kind of business is it?

Not all businesses are made equal, some operate in much riskier areas where there’s greater potential for things to fall apart. Research the market you’re lending to – it will help you understand the risk a bit better. For example, if you’re lending to fund a property development, as is becoming increasingly popular on P2P platforms, do some research into the geographic region the property’s in. That will allow you to figure out if the house price valuations you’re quoted are realistic.

Is the reward worth the risk?

Having tried to assess the risk as best you can yourself and taking into account the credit rating the lending platform has assigned the loan, you should then think about if the risk is worth it. If you’re taking on more risk, you’ll want to be adequately compensated with higher interest rates. Remember, only you can determine what counts as adequate. Definitely look at different platforms and compare rates on loans to give you a better idea of what’s fair.

How To Lend Safely

P2P platforms sometimes market themselves as being equivalent to a savings account at a bank, but in reality they’re riskier. P2P lending is investing and, as with all investments, you should only put in a portion of your overall wealth. It’s probably sensible to make it a small part of a broader investment portfolio that includes things like stocks, bonds, and index funds too.

Anything else I can do to mitigate risks?

I know we’re sounding like a broken record but diversify! Not only across individual loans but across platforms too. Different platforms have different measures of risk and different types of borrowers, so by lending through a few different platforms you’ll be spreading out your risk.

Remember that to truly diversify, your P2P investments should be as uncorrelated as possible from your other investments. That means that their price movements should be affected by different things. If, for example, you own shares in a load of Irish property developers and you’re also lending P2P money to build apartments in Dublin, you haven’t really added any diversity to your portfolio.

Above all, we’d say that you can never do too much research. It’s your money and you want to be sure you’re investing it wisely. Take the criteria we’ve gone through in this pack and apply them to a few different platforms – you’ll get a much better understanding of the different options available to you.

And if after all this you’ve decided P2P lending isn’t for you, don’t worry! There’s a whole host of other investment opportunities available. Check out our pack on Investment Choices for an overview, or delve into our packs on Property Investing, Stock Picking and Equity Crowdfunding for more detailed insight into those sectors.

In this Pack, you've learned:

  • Convenience is a key benefit of P2P. For borrowers, that's in addition to the lower costs compared to bank loans – and for lenders, that's in addition to the bank-beating interest income they can generate.
  • P2P lending is illiquid, and your risk of losses primarily depends on who or what types of businesses you're lending to.
  • When choosing a P2P platform, be mindful of fees, how much control you have over how your money's loaned, and what plans are in place in case of a default.
  • When assessing a borrower, due dilligence is key. In essense, you need to feel confident the risk you're taking is worth the potential reward.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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