Peer-to-peer lending has been regulated by the Financial Conduct Authority (FCA) since April 2014.
As a result, peer-to-peer providers now have to offer clear information and make savers aware of the risks, while those with complaints about peer-to-peer firms can take their cases to the Financial Ombudsman Service.
However, FCA regulation does NOT mean your cash receives the same protection as it would if held with a bank or building society.
The companies offering savings plans of this kind remain outside the Financial Services Compensation Scheme (FSCS) which protects the first £75,000 of savings per person. So savers could still lose their money should the peer-to-peer firm go bust.
Fortunately, you can reduce the level of risk involved by carrying out a few simple checks of your own. Here’s our top five.
1. Who are you lending to?
Not all peer-to-peer lenders are the same. And one of the biggest differences between them is that, while some lend to individuals seeking a personal loan, others provide funding for businesses or mortgages for property investors.
While Zopa, Lending Works and RateSetter lend money out to individual consumers, Funding Circle uses savers' money to offer business loans and Landbay funds buy-to-let investments. Wellesley & Co specialises in asset-backed lending to small businesses and individuals, so the funds you pay to Wellesley may, for example, be loaned to investors in residential property.
RateSetter claims that statistics show businesses are more likely to default on loans than individuals. And Wellesley & Co argues that having your investments backed by bricks and mortar reduces the risk of you ending up out of pocket. Director and co-founder, Andrew Turnbull, said: "At Wellesley, we insist on the loan being secured against a tangible asset, in this case property."
But you need to weigh up the pros and cons for yourself, and look at exactly who your money will go to before making your choice. Our article, Are peer-to-peer firms all the same?, will help.
If you have other investments, it is also worth considering how the type of loans being offered fit with the rest of your portfolio. You may, for example, want to avoid investing in mortgages if you already have a buy-to-let property of your own.
2. What credit checks are carried out on borrowers?
Whether peer-to-peer companies lend to individuals or companies, it is critical that they conduct stringent checks before providing a loan. After all, you wouldn’t lend money to someone you didn’t know, so it follows that you also need to be happy that your money will only be lent out to those with a very good chance of paying it back.
To this end, all reputable peer-to-peer lenders should be happy to demonstrate how they vet potential loan recipients, and provide details of the level of defaults they have had to deal with over, say, the last year.
You can also look out for companies, such as RateSetter, that use the credit reference agencies Equifax and CallCredit to check out potential borrowers.
3. Is the company financially strong?
When you put your money into a savings account provided by an FCA-authorised bank or building society, you are protected to the tune of £75,000 (or £150,000 for joint accounts) by the FSCS.
However, as previously mentioned, this is not the case with peer-to-peer lenders, so it is a good idea to do some research into a company and its financial strength before investing.
The FCA requires all peer-to-peer lenders to have a capital "buffer" of at least £20,000 in case they run into financial difficulties, increasing to £50,000 in April 2017.
However, other checks that you can carry out for this purpose include that the firm has a Consumer Credit Licence number (this should be displayed on its website).
And you should also only invest with regulated firms.
4. Is there a compensation fund?
However much checking is done, there will always be borrowers who are unable to repay loans due to unforeseen circumstances.
So it makes sense to only invest your money with a peer-to-peer lender that has a compensation fund at the ready should things go wrong – even though most companies reduce risk by spreading your savings between multiple borrowers.
Things to check include the size of the fund and how it stacks up compared to the amount the company could have to pay out.
Zopa’s Safeguard fund, for example, currently holds more than £12million which is 1.2 times larger than it expects to cover. RateSetter goes further with a fund of £17m which offers 132% of cover against predicted claims. RateSetter also requires some borrowers (such as property developers) to provide security against their loan, such as cars and residential properties and it estimates this to be worth £152million.
Lending Works offers a facility called Lending Works Shield which is split into two parts; a reserve fund which is held in Trust and, unusually for the industry, an insurance policy held with a UK-based insurer that protects against 'extraordinary' risks such as a major economic downturn.
5. Can you get your money back early?
If you're thinking of committing your funds for a year or more, it's worth checking whether you can get access to your funds early, should you need to.
Wellesley & Co, for example, has an Early Access Facility, but this will depend on whether another lender is willing to take your place at the same rate and term. And you will have to sacrifice some interest.
Similarly, RateSetter's Sell Out feature allows you to withdraw your funds early so long as there are investors who can take your place. You may have to pay a fee.
We have produced a hub all about peer-to-peer saving where you will find everything you need to know and more.
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.