Is peer to peer lending worth the risk?
"I'm thinking of borrowing through a peer to peer site. Is it worth the risk?"
Peer to peer (P2P) is a relatively new way to lend and borrow money online.
The principle is simple: the sites hook up those with money (investors) with those without (borrowers) in return for a fee.
Investing through a P2P site currently offers far better rates of return than ISAs and interest rates for borrowers are very competitive, too.
But what if the borrowers don't pay? Or the investors raise their interest rates?
In this guide we take a look at how the market works and ask: is it worth the risk?
Why peer to peer lending?
In the UK, peer to peer lending was pioneered by Zopa (short for 'zone of possible agreement').
The site launched in 2005 and, as of April 2016 when we updated this article, members have loaned each other more than £1.42 billion.
In the past 12 months they've loaned more than £472 million - compare that to the £575 million they loaned in total up to summer 2014.
Zopa are still the best known P2P lender, but there are now around 30 similar companies in the marketplace, including their two main rivals Funding Circle and Ratesetter, offering competitive deals.
A typical site offers investors returns of up to around 6.5%, with some offering up to 7.4%.
Borrowers, meanwhile, can often obtain credit at a lower rate than they could from a bank. It's possible to get a loan for up to £25,000, although the average is around £5,500.
What are the risks for savers?
The higher rates of interest that investors (savers) can enjoy through social lending aren't entirely risk free.
No FSCS protection
P2P websites aren't covered by the Financial Services Compensation Scheme (FSCS), which guarantees most UK savers for up to £75,000 with each PRA-registered institution, in the event of a bank or building society going bust.
Find out more about the protection available for UK savers under the FSCS in our full guide, here.
However, the sites do have substantial funds ring fenced in order to ensure that customers can be repaid. These systems have proved effective so far: Yes-secure is the biggest P2P casualty so far, having been forced to close down in 2014, for example, but they still repaid everyone who had invested with them.
FSCS protection is also not to be confused with FCA regulation. Since April 2014, P2P sites have been regulated by the FCA, which means that they must present their products transparently and have adequate protection, or face fines or sanctions.
There's not an exact parallel between P2P investing and saving, however.
P2P lenders don't always guarantee a return on invested money - and the interest can depend not only on the amount put away and for how long, like a normal savings account, but on whether the lenders default or pay late or if a borrower chooses to repay their loan early.
However, the risk is much lower than that description might suggest, for several reasons.
- Defaults are low: Zopa's average default rate is 0.71% for the past three years; Ratesetter's is 1.69%.
- Accounts are diversified: Savers always lend to multiple borrowers, with each borrower getting between £10 and 1% of any one lender's money, to diversify risk of payment default.
- Provision funds dampen exposure: Sites hold big funds in order to repay investors in case of problems. Zopa's Safeguard fund, for example, repays money with interest when a borrower is more than four months behind on their loan. Ratesetter use their £18 million fund to ensure that investors don't miss a single monthly payment.
- Independent contracts: The lending contracts between borrowers and investors should endure even if the P2P lender itself ceases to exist.
Of course, there is a risk of not getting the interest rate as advertised but P2P sites do work hard to make it a small one.
In July 2014, Ratesetter became the first P2P site to get an agency risk rating and were assessed as having very low volatility.
Like savings interest, P2P returns are included in the Personal Savings Allowance (PSA), which lets us earn up to £1,000 in interest tax free each year - but when we do have to pay tax, it's not as straightforward as with standard interest.
That's because we're liable for tax on the full amount by which our money has grown, not the amount we receive.
Say, for example, we've earned £200 in interest on our investment over the course of the year - but we've incurred £25 in fees. We've made a net gain of £175 - but it's the full £200 that we'll need to bear in mind when calculating any tax we owe.
The onus is on us to declare that income on our self assessment form - or, if we only pay tax through PAYE, to get in touch with the tax office and have our tax code updated to reflect the extra income.
Some P2P sites can help with this. Find more on the HMRC site here.
With the introduction of the PSA, this is less of an issue for many people - but should we need to think about paying tax, here are some effective rates of interest after tax has been taken into account.
|Advertised interest rate||After 20% (basic) tax rate||After 40% (higher) tax rate|
This also doesn't take account of any fees or bad debts that we may be subject to - and these can vary depending on the lender and the fund.
Zopa, as mentioned, offer Safeguard - a fund earmarked to protect savers from bad debt - to their Access and Classic investors, but not to Plus investors, whose money may be loaned to those with risk ratings from A+ to E.
Funding Circle offer lenders the chance to loan at different levels of risk, rated from A+ (least risk) to C- (most risk). Ratesetter only lend to people who match what they call their "stringent criteria" - which tends to mean only those with excellent credit histories.
What are the risks for borrowers?
Currently, one of the biggest risks for those looking to borrow is not having an application accepted. Acceptance rates are rising, but the industry average is pretty low - between 10% and 15%.
Different P2P sites have different requirements: some, like Funding Circle, only lend to businesses. Others will consider loans to both individuals and business. When it comes to "personal" loans, then, both Zopa and Ratesetter require that borrowers:
- Be able to provide UK addresses for at least the past three years
- Have a minimum regular income (Zopa say this must be at least £12,000)
- Have a good credit history
Zopa will lend to people aged 20 or above; Ratesetter ask that borrowers be at least 21.
The good news is that potential borrowers can often find out quickly if they'll be accepted, and at what kind of interest rate, by applying for a quotation - not for the full loan itself.
Both Ratesetter and Zopa use "soft searches" with the credit agencies to check our basic situation when providing us with just a quotation. Unlike the full credit search, which is carried out when we make the actual loan application, they don't leave a mark on our files.
Full credit searches can and do damage creditworthiness if we're not careful: anyone making multiple applications that require full checks will have those applications noted on their file - and lenders prefer not to lend to those who seem to be taking on a lot of credit.
The soft search lets us shop around before committing to the full credit check - reducing our risks all around.
Zopa use CallCredit and Equifax for their soft checks, and CallCredit for full credit references.
The obvious cost is the amount of interest and fees.
Just as in the mainstream, peer-to-peer lenders offer interest rates dependent on creditworthiness.
Rates can vary between 7% and 24%; social lenders aren't always cheaper than the banks.
Sites also charge fees to those taking out loans with them; the "borrowing fee" will usually cover the cost of arranging and managing the loan, a contribution towards any lenders' protection fund that's in operation, and any commission payable by the site for our business.
As a result the fee we're charged can vary considerably, depending on the details of the loan, including the amount and term. We've included another P2P lender - Lending Works - in the table below to show just how much fees can vary from company to company:
|£1,000 over 12 months||£25,000 over five years|
Most P2P lenders add the fee to the overall loan balance, so it's paid off over time as part of the monthly repayments.
What if a site goes bust?
Another obvious risk is that one of these small, in banking terms, peer to peer lending sites could go bust.
As we've already discussed above, site's investors aren't covered by the standard compensation scheme used by banks, building societies and credit unions - and it's unlikely that they will be any time soon.
Social lending sites do make their own arrangements to protect customers should they go out of business, however.
The contracts made between borrowers and lenders are legally binding and stand apart from the sites. Therefore, even without the sites involvement, lenders could continue to receive repayment and borrowers would be obliged to continue to repay their investment, at the rates agreed at the beginning of their association.
The Quakle example
We saw how this works in practice, however, when Quakle, a small peer to peer lender, went under in 2011 and when Yes-secure went under in 2014.
Quakle had long been on shaky ground, barely lending at all in the year before their demise, and in the aftermath we could see why: they were allowing people with decidedly poor credit to borrow.
Many of these borrowers were coming to Quakle because their alternative was a payday loan. Others were already deeply mired in debt, looking for extra borrowing to help them meet their repayments.
Those looking to borrow were upfront about their histories but said they were coming to the site to change: "help me to get out of a cycle of high interest debt", they said - and sympathetic lenders promised to help.
Unfortunately, good intentions didn't translate to a good level of repayments and, without the infrastructure of the site, pursuing these lending agreements seems to have stalled. As far as we know, lenders more or less lost their shirts.
How relevant is this?
So the Quakle example shows that peer to peer lenders are pretty risky, right?
Actually, not so much. Quakle were very different from the three big peer to peer lenders.
They were, as we've heard, more of a social lender: they allowed people to publish their individual stories, skewing the type of lending that was going on.
They weren't properly checking their borrowers' credit records and awarded them ratings from A to C that seemed out of step with their actual history (in other words, dressing up risky loans to look less risky).
This approach is very far from what the big three P2P lenders are doing. As we noted above, the problem - if anything - is that borrowers are turned away.
However, it does underline the very first risk we noted up at the top: these sites aren't FSCS protected - so while they are doing their best to ensure investors are covered, the risk of shirt loss is still real.