Here we will take a look at peer-to-peer lending, the risk involved and how it’s mitigated to establish whether this is one of the better investment opportunities for you, the investor.
Peer-to-peer lending risk v reward
As interest rates go, peer-to-peer lending exceeds those on offer from most asset classes. The stock market has taken a hit this last year, with many markets in a “bear” territory – market prices falling encourage the selling of shares – falling 20% and with bank interest rates (Bank of England) at a historic low of 0.5%, P2P lending could be a new way of investing money and earning those returns in the region 5% per annum avg. What risk is associated in order to achieve these returns? Let’s evaluate:
Borrower default: how the risk is mitigated
The no.1 risk associated with peer-to-peer lending is a borrower defaulting on their loan and you losing all your money. P2P lending is not covered by the Financial Services Compensation Scheme either so there is no compensation if your money is lost. Here are the key safety procedures imposed by P2P platforms to mitigate this risk:
1. Asset security
Many UK peer-to-peer lenders, such as Wellesley & Co, securitize their loans with tangible assets that can be sold to repay investors should a loan default.
2. Provision fund
RateSetter were the first to introduce a safeguard, or provision fund, but most major P2P platforms have followed suit. The fund will pay out on borrower defaults at the discretion of the Directors (in many cases) and assuming the fund is of adequate size. Find out how some UK peer-to-peer lender provision funds operate here.
3. Diversification
The number one rule when investing: diversify. With peer-to-peer loans your investment is spread across a number of borrowers, ensuring you don’t put all-your-eggs-in-one-basket. This spreads the risk and mitigates a single borrower default affecting your capital investment. RateSetter and Zopa retain very low default rates due to spreading a single loan amongst hundreds of borrowers.
4. Strict lending criteria
All UK peer-to-peer platforms will boast a rigid and robust lending criteria. The fact of the matter is, you yourself will rarely see who it is you are lending to. Transparency is key, and with major UK P2P platforms making it clear your investment is ‘auto-diversified’ between individuals, property and SME business loans, you can be sure they adhere to extremely strict rules, lending to only creditworthy borrowers. Christina Farnish, Chairperson of the P2PFA announces industry default rates are at a lowly 2-3% presently.
High interest rate reward
So it’s clear that peer-to-peer lending can offer one of the best saving rates (if deemed saving rather than investment) around so let’s take a look at what you could earn if you took your April ISA allowance, invested it an Innovative Finance ISA (IFISA) and lent through P2P lending.
Peer-to-peer lenders as ISA Plan Manager
Open an IFISA with a given P2P lender
RateSetter 6% per annum annualized rate IFISA
£15,240 ISA allowance can be invested
Interest received is tax free
So, you could receive £914.40 tax-free interest in one year. The ‘peer-to-peer ISA’ as some are calling it requires a closer look, seeing as it is new and there’s some complexity regarding withdrawals and transfers, so find out more here. You can, of course, invest in products outside of the IFISA, but be sure to compare the many platforms and products on offer by visiting Orca Money.
