FundingKnight: new peer-to-peer lender offering 11.4% returns

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A new peer-to-peer lender named FundingKnight claims to offer lenders an incredible return of more than 11%. Is it too good to be true?

FundingKnight, a new peer-to-peer lender, has launched promising lenders fantastic returns.

Like Funding Circle, (which is one of the three biggest players), FundingKnight is about lending money to small, UK-based businesses with at least two years of company accounts on public record.

Just like the other peer-to-peer lenders, before you can bid to lend your money to a company, FundingKnight weeds out businesses that it believes are too risky. A short explanatory video on the FundingKnight website explains: "Our processes mean that we cast out the riskiest loans.

What's left are the loans that we'd be willing to invest in ourselves and these are the only ones we offer you."

This service is very new, so there are currently just 11 different loans that you can take part in. You can contribute as little as £25 to a loan, which enables you to easily spread your money between different loans to reduce the risks.

How it works
Just like Funding Circle, with FundingKnight you can specifically choose which companies you want to lend to or you can bid automatically if you don't want to choose for yourself.

As usual, investors compete to lend money to prospective borrowers through auctions. The more of you there are competing to lend money to a borrower, the lower you'll have to pitch your interest rates to win the bidding war.

You can also buy and sell existing loans through FundingKnight's Loan Exchange. Loan Exchange enables you to free up invested cash within a few days or to reinvest it elsewhere. If you're buying a loan with new cash, it enables you to invest your money in the loan over a shorter timeframe, since some of the loan has already run its course.

In return for the benefit of a shorter loan, with quicker access to your cash at the end of it, the loan seller might require that you buy the loan at a higher price, meaning you can expect to get paid a lower interest rate than the original investor was getting.

Competitor Funding Circle allows you to get out of existing loans in a similar way, and Zopa will let you do so in many circumstances, but FundingKnight goes one step further: it allows you to sell a piece of your part of the loan.

Let me untangle that tongue twister with an example: if you've contributed £1,000 towards a £25,000 business loan, you could sell, say, £500 of it on the exchange; you don't have to sell all £1,000 of your holding.

Unlike the other peer-to-peer services, individuals don't pay a fee for investing or for earning interest. It is also fee-free to exchange loans, at least until 1st July 2013. Richard Watts of FundingKnight told me: "It's yet to be determined if and when fees will be introduced" to the Loan Exchange.

If you're wondering how FundingKnight might be able to run its service without charging investors any fees at all, I would presume it's because it hopes its 1% charge to borrowers will cover all its costs.

What returns are investors getting?
Investors have so far been offered interest rates between 9% and 12%. 11.4% is the average rate currently available, based on investing £25 in each of the best-priced loans currently on offer on the FundingKnight Loan Exchange. Note the text in italics, which emphasises that 11.4% is not the average across all loans.

On the surface, 11.4% seems seriously impressive, but, so far at least, it looks like you're generally not going to be able to invest in butchers, hair dressers, or other duplicated businesses that have been operated successfully thousands of times, and which therefore have fairly predictable profits.

Instead, we're talking businesses like cereno, a telecoms company, and Freeway Surfacing, which paves roads. That's why many of the businesses might have greater potential for higher interest rates, but will come with greater risks too.

That said, FundingKnight isn't for start-ups, but existing businesses; for example, profitable ones that need more money to deliver on promises to major new customers.

11.4% is before bad debt
11.4% is the "gross" return, meaning it's before bad debts. It also doesn't include any eventual fees you have to pay if you want to exchange loans, if FundingKnight introduces them.

The biggest peer-to-peer lenders usually describe their average returns after bad debt. However, I don't think this omission from FundingKnight means we have to worry about its honesty; it simply hasn't been around long enough to give you any meaningful statistics on bad debts.

You'll pay income tax on the interest you earn. As with Zopa and Funding Circle, but not RateSetter, you won't be able to set off your bad debts against your tax bill. I expect the law to be changed on this at some point to bring the industry into line with other investments.

Even taking all this into account, 11.4% is still a very high gross return indeed. It would be foolish to expect such rates to continue. Just like with the other services when they started, as more investors compete to lend money through FundingKnight, they will drive interest rates down. Plus, some borrowers will default and fail.

On the information available I currently have no reason to expect that average long-term returns at FundingKnight will be a lot higher than any of the other peer-to-peer lenders, or that the risk will be lower than Funding Circle.

Other potential risks to think about
The major players have at least a few years' record of low bad debts. FundingKnight says: "In general default rates for established peer-to-peer lenders have been lower than forecast and it is our intention to establish a repayment record in line with the best performers in the industry."

As with the other you, currently aren't protected by the Financial Services Compensation Service if something goes wrong.

FundingKnight hasn't built up a track record to give investors some extra comfort in this new industry. The company is so new that it has never filed accounts as an active company. Indeed, it is so young that it would not pass its own test if it wanted a loan through itself!

That shouldn't necessarily put you off, but it's a potential risk factor.

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