Updated 25.04.16

Peer-to-peer lending enables savers to lend money and achieve higher returns than if they deposited their money with a bank or building society. The system benefits borrowers too, as they usually get access to lower cost loans than they would if they borrowed through a bank (you can read more about this at the end of this article).

Here, we take a closer look at how peer-to-peer lending works, as well as the potential returns and risks involved….

All peer-to-peer lenders are not the same

If you choose to invest with a peer-to-peer lender in order to boost your savings returns, it pays to look carefully under the bonnet of the particular scheme you have chosen.

Different providers charge different fees and offer varying levels of protection, so don’t assume they are all the same.

Alex Gowar, spokesman for one peer-to-peer lender, RateSetter, said: “The key piece of advice I’d give to someone who is considering peer-to-peer is to carefully reflect on the rate you can expect to earn. While contracts are fixed, rates of return can vary as they can be affected by bad debt and late payments. So when choosing a peer-to-peer operator, it makes sense to understand the risks and protections that are in place.”

What sort of returns can I expect?

The returns you can generate from investing with a peer-to-peer lender will depend on how long you can afford to tie your money up for, as well as any charges which may be deducted and the risks involved.

For example, at the peer-to-peer website Funding Circle, the average return across all investors who lent for one year or more was 7.1%, including all earnings after fees and bad debt but before tax.

However, this isn’t necessarily the actual rate you will get. This is because the returns you achieve will depend on the exact rates you choose to lend at, the risk grade of the businesses you lend to, and any losses you might experience. Businesses are graded A+ through to E, with A+ businesses being the lowest risk and E being the riskiest.

The minimum amount you can invest with Funding Circle is £20 and there is no maximum, so you can invest as much as you want.

If you are prepared to tie your money up for five years, then RateSetter’s 5 Year Everyday Account offers an annualised rate of 5.9% on your investment, repaid in equal monthly instalments, which can either be reinvested or taken as an income.

The minimum amount you can lend is £20, and there is no maximum.

Alternatively, the RateSetter 1 Year Everyday Account pays an annualised rate of 3.5%.

If you don’t want to tie up your savings for a long period of time, then RateSetter offers a Monthly Access option, which only requires a short-term commitment of 30 days investing. You can earn 2.80% on your investment,which is reinvested at the current rolling market rate, with interest accruing for every day your money is lent out.

Do I have to pay tax on my returns?

From April 2016, lenders can use the new Innovative Finance ISA to protect their returns from the taxman. Not all lending platforms have set them up yet, but as more come onto the market it’s likely to make a big difference to existing savers.

The amount that can be protected using an ISA is still capped at £15,240, but it’s possible to transfer in ISA savings from previous years if you have them.

If you invest outside an ISA, you can now earn up to £1,000 a year tax-free interest if you’re a basic rate taxpayer, or £500 if you’re a higher rate taxpayer.

How safe is your money?

Money invested with peer-to-peer lenders is not protected by the Financial Services Compensation Scheme, so there are definite risks involved in choosing to save with a peer-to-peer lender rather than a conventional savings provider.

However, peer-to-peer lenders do vet their borrowers very carefully, so your money is unlikely to be lent to anyone with less than an excellent credit rating. Funding Circle, for example, has very low annual bad debt rates of below 0.60% for its A+ band of borrowers.

RateSetter claims it is unique in peer-to-peer lending as the only operator to have returned every penny of capital and interest to every single lender, although of course past performance is no guarantee of future success. It is able to do this because of its Provision Fund, which lenders contribute to via their ‘credit rate’. If a payment is missed, then lenders can make a claim through the fund to ensure that that they don’t lose out.

Zopa recently introduced a similar scheme to help protect savers. The ‘Zopa Safeguard’ is a fund held in trust by a not-for-profit organisation, which means Zopa has no rights to the money in it. So if a borrower you lend to through the site is then unable to pay back their loan, the Zopa Safeguard will step in and repay all the money you are owed.

Peer-to-peer lending benefits both borrowers and savers

As mentioned earlier, it’s not just savers who can end up quids-in using peer-to-peer providers – borrowers can benefits from market-leading loan rates too. For example, Zopa offers an impressively low 3.3% APR representative on loans of more than £7,500 and up to £10,000, repaid over two to five years.  

Of course, the rate you’re offered will depend on how much you borrow, over how long and what your credit history is like, but you can see that peer-to-peer lending is definitely challenging the more traditional lenders.

Please note: Any rates or deals mentioned in this article were available at the time of writing. Click on a highlighted product and apply direct.

Peer-to-peer lending is regulated by the Financial Conduct Authority, but your money is NOT protected by the Financial Services Compensation Scheme. There is a risk you may lose some or all of your initial investment.