The first thing you will notice when you look at a list of peer-to-peer savings accounts is the interest rate. The interest rate is usually considerably higher than most traditional savings accounts – sometimes into double digits. While these interest rates are definitely achievable with a peer-to-peer savings account, there is a higher level of risk involved, and more caveats to consider when deciding whether to take the plunge with peer-to-peer investments or stick to more conventional savings.
Peer-to-peer lending, in its purest form, is lending your own money to individuals or businesses who need to borrow.
You sign up with a peer-to-peer lending company (Zopa, Funding Circle, Lending Works, etc.) which does most of the hard work for you, including credit, identity, and fraud checks against prospective borrowers. Potential borrowers declare how much money they want to loan – and, if they pass various checks, they’re matched against lenders, such as yourself, who are looking to get a decent rate of interest on their savings.
Some peer-to-peer lending companies specialise in lending to individuals or businesses in specific areas of industry or business, for example the building industry, the farming industry, investors in the property market, or small businesses, to name but a few. Other peer-to-peer lenders have a wider remit, providing loans to individual borrowers on the open market.
Applying for a peer-to-peer savings account is quick and easy, and is usually done online. As part of the process, you will need to supply some form of ID, such as a passport, and proof of your current address and any other addresses from the past three years, if applicable. With most peer-to-peer lending companies, you can open an account with as little as £10.
The main risk with peer-to-peer lending is that your savings are not protected by the FSCS (Financial Services Compensation Scheme), which protects traditional savings accounts held by banks and building societies. The worst case scenario with peer-to-peer lending is that you could lose your entire savings capital.
In reality, you are unlikely to lose everything because most peer-to-peer lending companies provide some kind of alternative security scheme for your funds. These schemes vary from firm to firm, so be sure to read all of the small print.
In order to ease some of your fears and to provide transparency, some peer-to-peer lending companies advertise the amount of defaults (i.e. missed payments) versus successful loans. Others have a fund of money that can be used to repay any losses you suffer due to defaults.
With the high interest rates on offer, it should never be overlooked or forgotten that peer-to-peer lending is a risky undertaking. Given the level of risk, and the lack of any guaranteed security for your capital, it is probably more accurate to call peer-to-peer lending an investment – and to treat it as such.
All peer-to-peer lending companies work differently, from who they lend to, the way they assess potential borrowers, the method by which they spread investments and the way they repay investors. Before choosing a peer-to-peer firm, make sure you read all of the FAQs and check some external reviews to ensure you fully understand how that company works.
In general terms, there are two ways in which you can manage your peer-to-peer investments:
You are in charge of managing your own account. You choose the individual loan or loans you wish to invest in, based on information provided online by the peer-to-peer company. This is a comparatively risky endeavour unless you are very experienced in making such decisions, and have the time and the willingness to do your homework. If, despite the risks, you are set on managing your own portfolio, then it is always sensible to spread your investment amount over a wide range of loans to lessen the risk of you losing all your capital, should one or more borrowers default on their loan repayments.
You let the peer-to-peer lending company do all the hard work for you. They will automatically spread your investment across different loans, based on the amount of time you wish to invest for, and the level of risk you have specified. Generally, the higher the risk, the higher the advertised interest rate – and thus the greatest return on your investment. Unless your borrowers default on their payments…
With so many variables – the amount of money you can invest, the differing level of risk with every loan, the amount of loans you can spread your money over, and the fact that you can choose to re-invest your capital when one loan ends – you will almost certainly receive a different rate of interest to the advertised one. The rate won’t necessarily be lower, but it’s worth remembering that the advertised rate is usually based on average returns over the period of one year.
Yes: peer-to-peer lending companies want to make a profit, and thus they charge a range of fees for their services. The core account management fee is usually (though not always) incorporated into the interest rate, but ongoing charges and fees differ from lender to lender. Always, always, always check the full list of fees and charges before you choose a peer-to-peer investment, as they can really eat into your returns.
Some peer-to-peer lending accounts specify from the outset the amount of time you need to invest – typically between one and five years – in order to receive the advertised rate of interest. Some will also specify how long you have to wait in order to get access to your invested funds – for example, 30 days. Beyond these, access to your funds is largely determined by the length of the loans you invest in.
If you need to gain access to your funds before the time you specified, you may have to pay an early withdrawal fee, and you will usually have to wait until the lending company can find another investor who is willing to take over your loan investment.
Any interest made on peer-to-peer lending is subject to UK tax – but you do get to use your personal savings allowance (PSA) if you have one. If you want a tax-free peer-to-peer alternative, there is an innovative finance ISA which works in the same way as conventional peer-to-peer investments, but you can use your annual ISA allowance to generate tax-free savings.
The FSCS does not currently protect money saved in a peer-to-peer account, so if your supplier goes bankrupt, you could lose your entire investment. Some peer-to-peer investment suppliers have attempted to mitigate this by developing their own compensation schemes. However, since these do not carry the full weight of a government-backed deposit protection scheme, they can be a poor substitute for statutory protection.
Most peer-to-peer investment suppliers offer information on their website regarding the health of their current investment portfolio. Past performance can’t be used to predict the future, however. All peer-to-peer investments, by their very nature, are more speculative than government backed banks.
Without being able to predict which investments are likely to succeed or fail, the best way to mitigate the risks associated with peer-to-peer investing is to split your deposits across a broad range of suppliers. Of course, this means you’re more like to be exposed to a supplier who fails, but it should help prevent you from having all your eggs in one basket and losing your entire investment at once. Of course, if you suspect from the outset that some of your peer-to-peer accounts may lose money, you have to consider whether any successful investments are likely to outweigh the losses you make elsewhere. You might find it simpler and less stressful to place your investment in a standard (and protected) savings account.
Most peer-to-peer firms offer investment and lending products. As such, they operate in much the same way a traditional bank would, lending savers’ deposits to borrowers at a rate of interest which is higher than they pay savers. The peer-to-peer firm, therefore, takes the difference between the two interest rates as their cut. All of their overheads – staff, technology, risk assessment, debt collection, etc. – are paid for in this way.
If you have used an innovative finance ISA (IFISA) to invest with a peer-to-peer company, any gains will be made tax-free. If you have invested in a product outside of an ISA, standard savings tax rules apply. Therefore, assuming your returns do not exceed your personal savings allowance, you won’t pay tax. If your returns exceed your annual allowance, you will be taxed at the same rate as your normal income.