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Investing in peer-to-peer loans has become increasingly popular in recent years as income-seekers struggle to find a decent return on the high street.

Rock-bottom interest rates mean it’s virtually impossible to get a return that beats inflation from a savings account or Cash ISA.

Peer-to-peer (P2P) loans are viewed as something of a halfway house between cash and investing for many people – they offer better returns than cash but are not quite a full leap to putting your money in the stock market. It is important to realise, however, that P2P loans are a form of investment and comes with the risk that you may lose money.

P2P investing is when you lend money to a borrower – an individual or a business – through a middleman company, known as a platform. The money is loaned for a set period and the investor receives a rate of interest of that time and should get their money back at the end.

Many P2P providers split your money up into small chunks and spread it across a number of different loans. This helps reduce your risk as it means that if a borrower defaults on their loan you only have a small proportion of your money exposed to that loss. Several providers also have a contingency fund which is designed to pay out to cover any losses in the event of a default.

In 2016, as the popularity of P2P was growing, the government introduced (yet another) new type of ISA. The Innovative Finance ISA, or IFISA, lets you invest in peer-to-peer loans through an ISA so the income you receive on your investment is tax-free.

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Take-up of this type of ISA has been relatively low so far. In their first year just 5,000 IFISAs were opened, with a total of £36 million invested. In the 2017/18 tax year, a total of £290 million was put into 31,000 IFISA accounts. Optimists expect these numbers to pick-up as P2P becomes more mainstream and as providers build up their track records and prove they are viable investments.

Longevity is Important

For those who are interested in P2P, it is important to do your research before you invest. Neil Faulkner, founder of P2P comparison website 4th Way, says a good place to start is by looking how long a provider has been running and how much money has been invested through them.

Zopa is one of the original incumbents in the sector for example, and has loaned £3.9bn since 2005, according to figures from 4th Way. That compares with Proplend, which has loaned just £60 million since 2014.

Another important measure to check is the bad debt ratio. This is the proportion of borrowers who default on their loans and has increased in recent years as providers have become slightly less picky over who they lend to. 4th Way says that in its first year Zopa approved just 0.5% of applicants who applied for a loan, for example, but today it approves around 20%.

Finally, you should consider how much interest you are looking to earn and how much risk you are willing to take. The rewards on offer vary greatly across the various providers but, as with any investment, typically a higher level of interest will indicate a greater level of risk. Also worth checking is the difference between the rate of interest the borrower pays on their loan and the rate of interest you receive as an investor. The larger the gap is the greater the cut the middleman is taking.

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Ben Yearsley, director at Shore Financial Planning, says: “Not everything is the same in IFISA world and the charges can be opaque. But one simple rule that does stand is: the higher the interest on offer, the more risk you are taking with your money.”

How Much Involvement Do You Want?

Once you are comfortable with the idea of peer-to-peer, you need to decide which type of lending you want to do. You can lend to individuals or to businesses, for example, and you self-select individual loans for yourself or let the provider allocate your money for you.

Typically, the latter option tends to be more suitable to those who are new to the field as you don’t have to do the heavy research that picking individuals loans requires. With this option often you money is spread across a number of loans automatically, which reduces the risk you are taking, whereas if you cherry-picking loans you need to ensure you are sufficiently diversified yourself.

Yearsley says: “With the managed version you are, in essence, investing blind. You invest in a pool of loans, which might have a common theme, but you don’t know who the individual borrowers are. With the self-select option you choose exactly who you are lending your money to.

“The question investors need to consider is how much involvement they want with their investment and whether they have the time or expertise to assess the prospects and risks of individual loans.”

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person’s sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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