Introduction to Peer-to-Peer Lending

Introduction to Peer-to-peer lending

Peer-to-peer lending in the UK is becoming increasingly popular. However, do we completely understand it? Hopefully our introduction to Peer-to-Peer lending in the UK will clear things up a little.

While peer-to-peer lending obtains most of the media coverage, we are also going to investigate peer-to-business lending in the UK, as in my opinion this is the more sensible alternative for investors. This is why have am carrying out an experiment in personally investing in Funding Circle and why I have completed this Funding Circle review. In short, Funding Circle looks like a great option for ordinary investors to get involved in this growing sector.

 

What is peer-to-peer lending?

Banks in the UK currently offer a huge gulf between their savings and lending rates.

For example, at Lloyds Bank, borrowing £5000 over 3 years as a personal loan would be charged at 12.9% APR:

Introduction to peer-to-peer lending - Lloyds loan

Their best instant access saving rate, on the other hand, is a mere 1.00% AER.

Introduction to peer-to-peer lending - Lloyds saving

It doesn’t take a mathematician to see the discrepancy between what the banks.

Lenders want lower rates, and investors want higher. Well, why don’t they just meet in the middle? They did, and peer-to-peer lending was born.

 

How does peer-to-peer lending work?

The recipe involves a lender, a borrower and a middle-man. This middle man is the peer-to-peer lending company. Their first role is to perform background and credit checks on the potential borrowers. They then match these suitable borrowers to potential lenders and, finally, they collect the repayments and interest from the borrower and provide it to the lender. They do all this for just a small fee.

In some cases, as we’ll come to later, the lending is made to other individuals, typically known as peer-to-peer lending. However, as with Funding Circle, the borrower can also be a business, and this is often referred to as peer-to-business lending.


What are the benefits?

The benefit for the borrower is reduced rates. If we take zopa.co.uk as an example, borrowers can take out a loan at an interest rate of 4.8% APR. This compares very favourably to the 12.9% offered by the bank:zopa rates

For investors, you can earn interest on the investment at rates which greatly exceed the bank equivalents. Again, zopa.co.uk, after fees and prospective bad debts, provides a gross return of 3.9%. This compares to 2.1% gross return for the 3 year fixed bond with the bank.

Another benefit for both the investor and borrower is flexibility and liquidity. For the lender, if you invest in a 3 year fixed bond with Lloyds, this money cannot be accessed until maturity. However, with peer-to-peer lenders, they tend to offer an “emergency access” where you can get your money back for a small fee. For the borrower, you can repay your loans early with no early repayment fees.

 

What are the risks?

There are a few risks involved at present, which you will need to analyze against the potentially higher returns:

  • Firstly, the Government-backed Financial Services Compensation Scheme does not apply to per-to-peer lenders. Therefore, unlike in a bank or building society, your first £85,000 per person isn’t backed by the government if the financial institution was to go bust.
  • Peer-to-peer lending isn’t currently regulated in the UK and the FCA is unlikely to start regulating the industry until April 2014. However, this doesn’t necessarily suggest the industry is shady, as all major players have actively gone on record to state that they encourage regulation.
  • It is all new. With anything new, the rewards are often greater, but this is compensating for the risk of the unknown.

For investors, return rates range from 3-5% depending on the site and the credit worthiness of the borrower. Whilst, these trump savings rates, I have some concern with lending to individuals. The examples on zopa.co.uk for their prime borrowers are as follows:

zopa reason 3

zopa reason 2

zopa reason 1

As a reader on moneystepper, you will be fully aware that new cars and home improvements are not good reasons to be taking out debt, and I fear that bad debt rates may increase in the future due to this poor financial decision making.

 

Lending to businesses?

But, when is taking out debt a good thing? If it generates profit and cash flow each month, and this is the fundamental principle of most businesses. Therefore, I personally think peer-to-business lending is a much smarter move.

The largest provider of this type in the UK is Funding Circle.

Funding Circle 1

A quick look at their sites explains the rates available and how it works:

Funding Circle 2

With Funding Circle, the returns are higher, you get to select your risk profile yourself, and the modification fees are much less than with zopa.

Every business who applies for a loan with Funding Circle has been assessed by their credit team and has typically been trading for 10 or more years.

Also, diversification in your loans will greatly reduce your risk, and Funding Circle again offers a great solution:

Funding Circle 3

 

Funding Circle – putting my money where my mouth is!

The interface looks great. The email support has been good, and all the statistics at Funding Circle gives you confidence in the proposed returns and business model. However, I don’t think that I can give a thorough Funding Circle review until I’ve tried out Funding Circle for at least 6 months.

Therefore, as of November 2013, as part of a balanced portfolio of investments, I am putting my money where my mouth is. As part of my diversified portfolio, I have invested £1,500 in Funding Circle as a small test. This amount is large enough to ensure that my portfolio of loans will be diversified (I can split 75 different £20 loans), but small enough to not risk too much on a “test”.

I will keep you all updated how it gets on with my Funding Circle Review in April/May 2014. In the meantime, why not come and join me…

 

Budget 2014 Update

If peer-to-peer lending wasn’t enticing enough, it has been revealed in the 2014 budget that peer-to-peer lending will now be allowed to be held in ISAs, meaning that returns will now be tax free. This is a huge benefit to the industry as a whole and great for peer-to-peer lenders, such as myself!! 🙂

 

Funding Circle Lending Results

To see my results and a much more in depth analysis of how to optimize your Funding Circle returns, see our Funding Circle Review article.

If you found this information useful, I would be hugely grateful if you could share with your friends via social media:

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5 thoughts on “Introduction to Peer-to-Peer Lending

  1. We have Lending Club and Prosper as our two options for peer-to-peer lending. I’ve been slowly building up an account with Lending Club and plan to stop once I have $2500 invested. So far the returns have been pretty good and sit at over 10%. The account is only about 7 months old though so a lot of the money is in very young notes and none have actually defaulted yet.

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