Consistently poor rates being offered by savings account providers have persuaded lots of people to seek alternative ways of getting a better return on their cash. And using a peer-to-peer lending website is becoming an increasingly popular option.
Since April 2016, it has been possible to hold peer-to-peer loans with an innovative finance ISA, which means returns are tax-free.
Peer-to-peer websites work by pairing up savers who want a better return on their cash, directly with people (or small businesses), who are looking to borrow at competitive rates. This good value on both sides is made possible as banks and building societies – and their costs – are cut out of the equation.
Peer-to-peer lenders have lent out an incredible £600 million of savers’ money since 2005, which is when the UK’s first peer-to-peer lender, Zopa, was launched.
Here, we look at how lending your cash through a peer-to-peer website works – as well as the advantages and disadvantages of doing it.
What is peer-to-peer lending?
As a peer-to-peer lender, you will lend your savings out to individuals or businesses, rather than keeping them in a traditional account with a bank or building society.
As a ‘lender’ you have a say about what interest rate you want to earn (within boundaries).
For most savers, the big draw of peer-to-peer lending is the fact that returns are highly likely to beat those available on the high street.
For example, if you are happy to take the risk of lending to people with lower credit scores, you’ll get a higher interest rate. And if you want the security of lending to people with excellent credit ratings, who are very unlikely to miss a payment, you’ll get a lower interest rate.
Peer-to-peer loan companies reduce the risk by spreading your investment over many borrowers, meaning that your rate of return should only be slightly affected should one of the borrowers default on his or her loan.
If you lend £2,000 through Zopa, for example, the sum will be split between at least 200 borrowers. It is for this service and the sourcing of borrowers in the first place, that you will charged a fee. The fees are usually factored into the interest rate you are offered, but always check so you know exactly what you are getting into.
How can you save via a peer-to-peer lender?
To become a peer-to-peer lender, you will first need to set up an account. This means supplying some personal information such as your name and address, choosing how long you want to tie your money up for (and in some cases, at what rate) and, finally, making an online transfer of the cash you want to invest.
What are the benefits?
For most savers, the big draw of peer-to-peer lending is the fact that returns are highly likely to beat those available on the high street. As already mentioned, you can boost these returns even further by lending to higher-risk borrowers – and for tying your money up over the longer term, say in a five-year fixed rate bond.
While better returns may still be available via the stock market, peer-to-peer lending also offers a less volatile – albeit a less liquid – income stream.
And, unlike many fixed-rate savings accounts, most peer-to-peer lenders allow you to invest as little as £10 or £20, while savers with larger amounts will benefit from the fact there is generally no upper limit on how much you can lend.
Savers can also opt to receive interest monthly, meaning that you can choose to reinvest this cash or keep it for other purposes.
Are there any risks?
Yes. Firstly, even though the peer-to-peer sector is regulated by the Financial Conduct Authority, your cash will not be protected under the Financial Services Compensation Scheme (FSCS), which would safeguard the first £75,000 (as of January 2016) of your funds if they were held in a bank or building society and it went bust.
Secondly, the advertised rate is not necessarily the actual rate you will get on your savings. This will be determined by the risk grade of the individuals or businesses you choose to lend to, how long you want to tie up your money for and the rates available at the time.
However, peer-to-peer operators have their own means of mitigating this extra risk, for example some share out your money among lots of different borrowers while other have a kind of insurance fund that savers collectively contribute towards, and which pays out should your loan be defaulted on.
Peer-to-peer lending websites also credit-check borrowers to ensure they can afford to repay your cash.
Are there any charges?
Peer-to-peer lenders are for-profit businesses that aim to make money. As a saver, you will therefore pay an annual servicing fee of about 1%, though this is generally taken into account in the advertised interest rates.
You will also face a fee if you need to access your money prior to the term agreed at the outset – for example three or five years.
Do I have to pay tax on my returns?
Not if you hold your peer-to-peer loans within an Individual Savings Account (ISA).
If you hold them outside an ISA, you can earn up to £1,000 a year in tax-free interest if you’re a basic rate taxpayer, or £500 if you’re a higher rate taxpayer. Earnings after that will be taxed at your normal rate.
Who to save with
There are lots of different peer-to-peer lending websites too choose from. Two of the biggest consumer peer-to-peer lenders are currently Zopa and RateSetter while Funding Circle will lend your money to small businesses and Relendex will allow you to secure £5,000 upwards against commercial property investments.
Make sure you always know what you are getting into before investing your cash with a peer-to-peer lender and weigh it up against other options, which include ISAs, fixed rate bonds, easy access accounts and even high-interest current accounts.