Peer to peer lending explained

On the face of it, peer to peer lending is a no-brainer for savers and borrowers. If you have savings you are able to lend to other people, you could make double the returns of a competitive savings account. Meanwhile if you want to borrow, you could end up with a better rate than you could get through a bank.

The attractions of doing business this way are so strong that the sector has doubled since last December, and the main websites have now lent more than £2 billion. So should you be abandoning the old fashioned way of banking for a peer to peer offering?

There are some definite benefits to this approach. However, peer to peer lending isn't exactly the same as borrowing or saving through a bank, so it's worth taking the time to understand how it works, and the risks involved.

The basic idea is that instead of involving a banking middle-man, lenders and savers use a peer to peer lending website which matches people with savings with those who want to borrow.

Cutting out the middle man means that they can cut a better deal - because they don't have to pay banker salaries or shareholder profits. It means savers will get roughly twice the return they would get from a bank - but if they are willing to take more of a risk, they could earn anything up to 16%.

The risks
However, this return comes with a risk. In a savings account, the middle man provides a safety net too, so going around him means you lose that safety net. The banks will lend to thousands of people, so that when a proportion of them fail to pay the money back, that can be factored into the deals they offer and no-one loses their money. In a bank, even if thousands of people fail to pay their money back and the bank fails, there's an official compensation scheme, so you will get at least the first £85,000 of your cash back. With peer to peer lending you lose both of these guarantees.

With peer to peer lending, you are lending direct to another person, so if they fail to pay up, you lose money. In that case, no-one will compensate you.

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Some protection
The websites will try to protect your money in a number of ways. In some instances the websites will offer a safety net of sorts, but if too many people default on their payments, these nets will not be able to protect all your money. The protection varies between providers, so it's worth checking each before you invest.

Most of the sites will also spread your money across a number of borrowers, to reduce your exposure to any one individual, but there's no way they can spread out your cash as broadly as a bank can.

They will carry out credit checks on every individual who borrows through the site too. The peer to peer website will rate each borrower according to the level of risk they feel they pose, so you know before you lend how much of a risk you are taking.

If something goes wrong, the website will also chase payments for you, so you don't have to start moonlighting as a bailiff. However, you do need to bear in mind what would happen if the website went out of business. The loan would still be repayable, and the site is required to have insurance to pay for a third party collection agency. However, you cannot assume that things will be seamless.
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The websites
Each site works slightly differently, so it's worth understanding the basics of the three major players.

Zopa has been around for nine years, and has lent out £623 million, so is one of the most recognised names. Last year it changed the way it functions in order to make things a bit easier for lenders. It means that - with one key difference - Zopa and Ratesetter now work roughly the same way.

They let you choose how much you want to lend, and how long for, and will spread your cash out among a number of borrowers for you.

The rate offered by these sites has factored in a typical number of failed debts, and a fee to its Safeguard fund. This means that if a borrower doesn't pay up, you will still get what you were promised, and it's up to the site to chase the borrower. This will work unless there is a surprising level of bad debts, in which case there will be a knock-on effect on lenders, and you may lose money.

The key difference between the two is the emphasis the different sites place on the different forms of protection. Ratesetter sets much of its reputation on its safeguarding fund - which has so far always compensated all is customers for unpaid debts. Zopa, meanwhile, places more emphasis on diversification - because using the company's services mean you will never have more than 2% of your money lent to any one individual - drastically reducing the impact of one loan failing.

Funding Circle is very different. It lends to businesses, and is much more of a basic peer-to-peer site. There are two ways to use it. Either you can personally choose each business you want to lend to (and the site recommends choosing at least 100 to be on the safe side).

Alternatively you can use auto bid, which selects a number of borrowers at random and spreads your risk for you. You choose a target interest rate for auto bid to work with, so if you set a higher rate, it will lend to riskier companies, and if you go for a lower return you're likely to lend to companies that the system considers to constitute less of a risk. In general, you can get higher rates through this site than the other two, but you will be taking more of a risk.

Small print
Whichever site you use, there are a few additional things to watch for. If you use this approach, you do have to pay tax on your returns, and will need to complete a self-assessment form for HMRC. It's worth factoring this cost and hassle into your calculations when working out whether peer to peer lending is right for you.

If your site offers you some protection, there's a good chance it will be partly paid for through an annual fee, so you need to factor this cost in too.

The other annoying issue is that you cannot offset the losses from bad debts or the annual charge against your gains. It means that if you invest for a return of 6%, even if the fees and bad debts mean your actually return is only 4%, you'll still have to pay tax on the full theoretical 6%.

In this year's Budget, George Osborne announced that peer to peer services should be allowed to make up part of your stocks and shares ISA. This will sidestep the tax irritations. However, at the moment none of the providers have managed to put together an offering, and it could be as late as 2017 before anything hits the market.

Most of the sites will ask you to lend for a specific period of time. Most will also allow you to withdraw your cash earlier. However, you need to check their rules, and the price you will pay for early withdrawal.

Deciding whether peer to peer lending is right for you, means going further than the headline rate and assessing the level of risk you would be happy with, and the rate of return you would get from it - after factoring in all your costs. It's not a no-brainer, but is it right for you?

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