Many savers are turning to peer-to-peer lenders, which match up savers or investors with individuals or companies looking to borrow money.
The popularity of these lenders, which include Zopa, Funding Circle, Ratesetter and Wellesley & Co, has rocketed over the past few years. The size of the peer-to-peer lending sector more than doubled in 2013 alone and in 2015 both Zopa and Funding Circle broke the £1 billion-lent barrier.
And with the Financial Conduct Authority (FCA) stepping in to regulate the sector and bolstering confidence as a result, not to mention the new Innovative Finance ISA that allows investors to earn tax-free returns on their lending, yet more savers and borrowers are likely to be enticed by the attractive returns and low loan rates on offer.
Peer-to-peer lending carries risks for savers, though. So we’ve put together this back to basics guide to help both savers and borrowers understand how peer-to-peer schemes work.
Savers (or ‘lenders’)
What is peer-to-peer lending?
By investing in a peer-to-peer scheme, you are essentially taking the place of a financial institution such as a bank by agreeing to lend money to people or businesses via an intermediary – the peer-to-peer lender.
The peer-to-peer company will usually spread your investment over many borrowers to reduce the impact 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.
As with a bank loan, the rate charged will relate to the level of risk involved.
In some instances, you can therefore decide whether you want to take the risk of lending to people with lower credit scores in return for a higher interest rate, or accept a lower rate in return for the security of lending to people with better credit ratings.
How does peer-to-peer saving work?
To set up an account with a peer-to-peer lender, you will have to supply personal information such as your name and address, choose how long you want to tie your money up for (and in some cases, at what rate) and transfer across the cash you want to invest.
You can find out more about the interest rates and offers available from peer-to-peer lenders quickly and easily on MoneySuperMarket’s peer-to-peer channel.
Are there any charges?
Most peer-to-peer websites used to charge lenders an annual servicing fee of about 1%, but this is no longer the case. (Borrowers usually pay a fee which is taken directly from their repayments.)
However, there will often be charges to pay should you need to access your money prior to the term agreed at the outset, which could be, say, three or five years.
This is because the returns on offer generally increase the longer you agree to tie your money up for – just as they do with fixed-rate savings accounts.
What are the advantages?
The superior returns available are the most obvious advantage of peer-to-peer lending. Some peer-to-peer schemes pay as much as 7%, which is significantly more than you can get on a standard savings account at the moment.
The terms are also more flexible than those you will find on most savings accounts.
Most peer-to-peer lenders allow you to invest as little as £10 or £20, while imposing no upper limit on the amount you can invest.
The good news for savers looking to generate income from their capital is that most accounts give you the choice of receiving your interest monthly or as a lump sum at the end of the term.
What are the disadvantages?
There are some risks with peer-to-peer lending. For example, the advertised rate is not necessarily the rate you will receive.
This is because the returns you achieve will depend on the exact rates you choose to lend at, the risk grade of the people or businesses you lend to, and any losses you might experience.
What’s more, although the peer-to-peer market is now under the auspices of the FCA, savers do not qualify for protection under the Financial Services Compensation Scheme (FSCS). Customers of conventional banks and building societies have protection for the first £75,000 of their funds should their bank or building society collapse.
However, it was recently announced that the FSCS may provide some investors with compensation of up to £50,000 if they received poor investment advice from a regulated firm since April 6, 2016. But that does not mean anyone losing money can simply claim it back – it’s an issue of receiving bad advice from a regulated provider.
However, that doesn't mean you're entirely without protection. Peer-to-peer companies try to mitigate the risks involved by splitting your money between many borrowers and carrying out credit checks on those looking for loans. Most lenders also maintain a compensation fund to cover losses in the event that a borrower defaults.
Wellesley & Co, for example, has a Provision Fund that is held in trust by a vetted independent third party and contains double the funds needed for savers to be reimbursed.
And Zopa’s Safeguard fund, which is also held in trust, currently holds more than £12 million, which it says is 1.2 times bigger than it expects to cover.
However, there is no doubt that peer-to-peer lending is less safe than putting your money in a bank or building society account.
Do I have to pay tax on my returns?
Thanks to a change announced in the 2014 Budget, peer-to-peer saving/lending can now be held within an Innovative Finance ISA. The first accounts were launched in April 2016 and providers are gradually rolling out their products for investors.
If you invest using an ISA then all your returns are tax free, so it’s a really good way to protect your money from the taxman. However, if you invest outside an ISA, you can earn up to £1,000 in savings interest-tax free each year if you’re a basic rate taxpayer, and £500 if you’re a higher rate taxpayer.
How do peer-to-peer loans work?
A peer-to-peer loan works just like an unsecured personal loan, except that individuals, rather than a bank or building society, provide the funds.
And as with loans from banks and other traditional lenders, the interest rate you are offered will depend on the amount involved, the length of time over which you want to borrow the money, and your credit score.
This is because the savers investing money will often earn less interest if they lend to people or businesses with better credit ratings.
How can you borrow money via a peer-to-peer lender?
Peer-to-peer lenders offer loans online as they do not have branches like traditional banks. Apart from applying and communicating online, however, the process is just the same as applying for a bank loan.
MoneySuperMarket lists the best peer-to-peer and mainstream loans so that you can compare the two and choose the right one for you – before applying through the site.
What are the advantages?
Peer-to-peer lenders have lower operating costs than traditional financial institutions such as banks – and that enables them to lend money out at typically lower interest rates.
For most borrowers, the main advantage of peer-to-peer loans is therefore that they are cheaper than those available from mainstream lenders.
In many cases, the loan terms are also more flexible. Zopa, for example, charges no early repayment charges should a borrower be able to clear his or her loan before the agreed end-date.
What are the disadvantages?
As with any loan, it is vital to check the terms and conditions of a peer-to-peer loan carefully before taking the plunge.
Even if there are no early repayment charges, you will face penalties for missing payments in the same way you would for failing to keep up with repayments on a bank loan.
So it is important to check what these are, and to remember that any late or missed payments will also be noted on your credit file – which could make it harder for you to get credit in the future.
Those looking for long-term loans may also find it harder to use a peer-to-peer lender. RateSetter, for example, restricts its loan terms to a maximum of five years.
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.