Savvy Money: Peer-to-peer lending can pay off – but there are pitfalls

If you're tempted to shun mainstream lending, make sure that you do your research first

Peer-to-peer lending can pay off – but there are pitfalls (Getty Images)

At a time when you will struggle to get 3 per cent interest on a savings account, earning a return of two or thee times that is understandably tempting. Peer-to-peer lending, which let individuals loan money to people or businesses, aren't a new idea; the first one – called Zopa – was launched in 2005. But a combination of the banks generating worse headlines than usual (Libor rate fixing and interest-rate swap mis-selling to name but two) and savings rates reaching new lows, have resulted in an increase in their popularity.

Lending basics

There is a growing number of peer-to-peer lenders. Most of the recent additions lend to businesses, leaving Zopa and Ratesetter the best known for lending to individuals. Funding Circle, Funding Secured, Thin Cats and Funding Knight are just some of the peer-to-peer lenders which let you loan your money to businesses (including, in some cases, partnerships and sole traders). The returns for business lending tend to be higher than in the personal-lending market, with sites offering anything from seven to more than 13 per cent after charges but before tax, compared to 4.6 per cent from Zopa and Ratesetter.

How is money protected?

Unlike bank savings, money lent out via a peer-to-peer lender isn't covered by the Financial Services Compensation Scheme (FSCS). In broad terms, this protects savings you have in banks and building societies up to a limit of £85,000 (normally per bank but it could be less if they are part of the same group).

Peer-to-peer lenders are due to be regulated by the Financial Conduct Authority from April 2014, although there are no plans to protect money via the FSCS.

Risk reduction

Some peer-to-peer lenders, notably Zopa and Ratesetter, have established measures to reduce the risk. Ratesetter has a contingency fund and Zopa has a “Safeguard” fund which aims to cover bad debts. Some of Zopa's users, who say they receive a lower return through Safeguard, aren't impressed, although Zopa says that lending has increased since it was introduced.

The industry also has its own association (the Peer-to-peer Finance Association) and companies that have joined it have to have certain levels of capital behind them and must keep individuals' funds segregated.

Track record and bad debts

If you are thinking of lending via a peer-to-peer website, I would recommend that you check out the track record of the lender, find out how it assesses potential borrowers and what its bad debt record is. Most publish this information prominently on their websites.

This is important because some peer-to-peer lenders have gone under (including Quakle and Big Carrots) and some haven't been going for more than a few months, so it is worth spending a bit of time looking at their business models.

Start small

Start small if you're new to peer-to-peer lending. Monitor how your loans perform and, if you're comfortable with the risk levels, you can always increase your exposure. Most sites will let you lend relatively small amounts, but Thin Cats has a minimum level of £1,000.

Charges

The rate of return should be quoted on the website after fees and charges have been deducted, and charges can vary. For example, Zopa charges a fee of 1 per cent on money that you've lent out, while Ratesetter charges 10 per cent of the interest you've received.

Don't forget about tax

Interest you earn by lending out money on a peer-to-peer site is taxable (just like bank savings). But unlike savings accounts, tax isn't generally deducted by the peer-to-peer lender. That means you have to tell HM Revenue and Customs unless you're a non-taxpayer.

Fees and charges are tax deductible. However, you have to pay tax on interest you should have received if the person or business defaults on the loan (something the industry is lobbying to change).

Verdict

The number of peer-to-peer users has increased dramatically and new lenders are popping up regularly. But they vary widely in terms of how they lend and who they lend to. You don't have the backup of the FSCS safety net, so make sure you research who you're lending to, how your money is held while it's not lent out and what could happen if the peer-to-peer site goes bust.

savvywoman.co.uk