25th March 2015
The peer to peer lending market continues to grow, while increasingly offering wider ranges of loans and better protection for investors in the event of borrowers defaulting.
Many thousands of investors, fed up with the poor interest rates paid by banks and building societies, have already turned to peer to peer lending to earn higher rates of interest on their money.
Peer to peer lenders match people wanting to earn a decent rate of interest on their savings with those needing to borrow.
Borrowers can typically obtain bank-beating rates from 3% per annum upwards across the peer to peer sector.
Rates can be even higher. For example, for more experienced borrowers, peer-to-peer lender Assetz Capital, offers rates from 9% to 15%, ranged across loans to businesses, property developers, buy-to-let mortgages and green energy.
Andrew Hagger, a financial product expert with moneycomms.co.uk, says: “With interest rates on cash ISA products at rock bottom, the option to be able to tap into an alternative market and earn a far greater return will undoubtedly appeal to those seeking improved returns.
“Banks seem to have lost interest in retail savings and this could play into the hands of peer to peer providers with more streamline business models, lower overheads and very attractive interest rates.”
The products work well for borrowers too, offering competitive rates and a fast alternative to traditional lenders. Borrowers can also repay their loans early without penalty.
But although the idea is almost the same as making a deposit – you earn interest by handing money over to be lent to someone who pays interest to borrow – the risks are quite different. It is very important to understand how these products work and the risks involved before handing money over.
How it works
As an investor, you register with a peer to peer lender, decide how long you want to commit your money for, and hand it over. Unless you deem yourself to be an experienced investor/lender, it may be best to start with a small amount to see whether this form of saving really suits you – deposits start as low as £10.
The lender then matches your money to borrowers who want funding for the same time period. Each scheme works somewhat differently.
The rates of interest advertised are gross of tax, and unless you hold your peer to peer money in an Isa, anything you earn will be subject to income tax at your marginal rate.
The most fundamental difference in approach is whether you are concentrating your loan on one borrower or spreading your loan across a number of borrowers. Some peer to peer lenders offer tools for you to select across the book or allocate automatically across their book.
For example, Zopa lends small chunks of your money to different borrowers, while Ratesetter usually lends all your money to just one borrower providing it finds the perfect match. Funding Circle lends business loans and will match several depositors to one borrower, the number depending on the size of the required loan. Assetz Capital allows investors to set up a strategy according to rates of return and predefined types of security on offer from borrowers and then allocates the money across loans fitting that profile.
Whether you can access your money early again depends on which peer to peer lender you have signed up with. Ratesetter does not allow early withdrawals. Zopa enables savers who want to retrieve their money to transfer existing loans to new savers for a 1% fee. If the lending rate on the loan is lower than that being paid on new loans, the investor may also have to make up the difference.
The traditional drawback
Many peer to peer loans, particularly with the some of the longer established sites, are unsecured. The biggest risk is that you might not be repaid, though lenders are increasingly taking steps to reassure their borrowers they are very likely to get their money back.
First of all, all potential borrowers go through identity, fraud and credit checks and are rated according to the risk they present of not repaying the money they borrow.
Nevertheless there are inevitably some loan defaults. Although peer to peer lenders have been regulated by the Financial Conduct Authority since April 2014, there are no savings guarantees on money lent through them.
This is in contrast to normal deposits made to banks and building societies are covered to the tune of £85,000 by the Financial Services Compensation Scheme, there is no such protection for peer to peer savers.
Instead, each scheme has its own way of dealing with defaults, starting with chasing the borrower for payment. Zopa and Ratesetter cover defaults by requiring borrowers to pay a small amount into a compensation fund at the outset.
Ratesetter was the first to establish such a fund in 2010, and as a result it says that despite lending £543,724,058, not one of its 20,602 savers has lost so much as a penny. Zopa followed suit, repaying savers their capital and interest once a borrower is four months behind on payments.
Many more recent entrants such as Wellesley & Co have made such schemes part of their approach just about from launch.
As yet Funding Circle does not operate a compensation scheme, and recommends that savers diversify by lending to at least 100 businesses, lending no more than 1% of their capital to each one with a tool called Autobid to help you do so.
However to answer this concern about security, more recently established players now offer substantial security.
The growth of secured peer to peer lending
Investors who find the prospect of carrying out unsecured lending a bit daunting may prefer lenders such as Wellesley & Co, which offers loans usually to property developers and secured on an asset, and Landbay, a peer to peer lender that specialises in lending directly to professional buy-to-let landlords.
Wellesley & Co actually lends money to each borrower in addition to money loaned by you. In the event of a default and the need to sell the asset, the borrower is paid back first. It also has set up a provision fund, intended to fund compensation to lenders, at their request, though it remains at the directors’ discretion.
The rates on these loans range between 3 and 6%.
Landbay offers interest on a three-year fixed rate at 4.4% annualised and a three-year tracker rate of 3.5%. The loans are secured on tenanted properties, with a first ranking mortgage i.e. its loans are do not exceed 70% loan to value.
The firm also makes the point that buy-to-let has proved to be a market with a strong performance record for its loans better than the residential market. In the event of a property having to be sold and a shortfall remaining, it has also set up what it calls a rainy day fund, to which borrowers can apply to make up any lost interest or capital, though with all these funds it is not guaranteed to pay out. Regulators do not actually firms to say they do.
Landbay also automatically diversifies lending across multiple properties in different areas to reduce risk for savers.
Assetz Capital also requires borrowers to provide substantial security for its loans across the three sectors, business, property development and buy-to-let. The firm also offers a Green Energy Income Account with a 7% return.
Finally Lending Works has set out its stall to be one of the safest peer-to-peer lenders on the market.
For borrowers, the firm offers one to five year loans with a minimum of £1000 but rising to £25000.
Borrowers are checked in detail with a credit reference agency, an affordability check, and checks for fraud. The money is held within a segregated fund, administered by a not for profit firm so that money is protected, even if Lending Works stopped operating. The firm also offers what is called the Lending Works shield. This is a reserve fund, covering defaults and fraud but also an insurance contract which protects against a major economic downturn so lenders are protected even if 10% of their borrowers fall into default.
The peer to peer market is growing consistently, helped by innovation from the companies concerned and government encouragement. When you are lending money, you are embracing a very different product from that offered by a bank and that is demonstrated by the fact there is no compensation scheme coverage. But many peer to peer lending offers better rates and are seeking to address concerns about defaulting.
If you make sure you know and understand these conditions, considering the sort of loans you are making and to whom, it can be a source of very rewarding returns.