Does peer-to-peer lending have a place in your portfolio

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Peer-to-peer (P2P) lenders have been offering savers a superior return to cash for over a decade without fully breaking into the mainstream.

They have "loaned" around £2bn in the last 12 months, but this nevertheless remains a drop in the vast ocean of UK savings. Arguably, market leaders Zopa and Ratesetter deserve better, given that they offer tempting interest rates of up to 5%.

Meet Your Peers

Some people still struggle to grasp the concept, but it's fairly simple. These "social lenders" raise money from savers and lend it to carefully vetted individual or business borrowers. By cutting out the middleman — greedy banks — both parties get a better deal.

Peer-to-peer lending is likely to get a major boost from next April, when you can take your returns tax free via Chancellor George Osborne's proposed "Innovative Finance ISA". The publicity should boost the profile of P2P lending and more than 400,000 people are expected to give it a go, according to research from Yorkshire Building Society.

Peer Protection

P2P lending is certainly worth considering. Ratesetter currently offers a five-year return of around 5.5% before tax, assuming you re-invest your interest. The new breed of excitable "crowdfunding" platforms are chancier, talking up the prospects of double-digit returns.

Zopa and Ratesetter are at the lower-risk end of the spectrum, but still risky. Your money has zero protection under the Financial Services Compensation Scheme (FSCS), which safeguards the first £75,000 held in a bank or building society savings account. Zopa and RateSetter are building up large contingency pots to protect their customers, who haven't suffered any losses yet. But they aren't for widows and orphans.

Fear Of Crowds

Crowdfunding involves asking a large number of people to each invest a relatively small amount of money in a spread of start-up businesses, which could be anything from craft ale to children's clothing to green energy or a myriad new technologies. Notable platforms include Crowdcube, Funding Tree, Property Crowd and Seedrs.

Given that half of UK start-ups fail within five years, the risks are clearly high, and you should only invest money you can afford to lose. Property investment schemes from P2P lenders such as Lindsay and Wellesley may be a little lower risk.

Peer pressure

So far P2P lending has largely avoided any whiff of scandal. Established players Zopa, Ratesetter, Funding Circle, Lending Works and Wellesley are working hard to keep the sector respectable. They know it will only take a couple of crowdfunding collapses to bring P2P lending into disrepute.

P2P lending does have a place in your portfolio, but only if you understand the risks, and how they vary according to the site. One attraction is that you can start small — some sites let you save from as little as £10 or £100 — and build up your stake as you get the hang of it.

Don't succumb to peer pressure next April, as there are still more potentially rewarding options out there. A wise investor will spread their money between cash, bonds, P2P lending and property, and also build a portfolio of individual company shares to tap in the unbeatable long-term returns you can get by investing in the stock market.

There are plenty of top UK stocks offering yields of 5% PLUS the prospect of capital growth on top, you just need to know where to look.

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Harvey Jones has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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