Peer to peer lending services aim to link up those in need of funds with people looking to make an investment. Some peer to peer lenders supply loans to individuals whereas others focus on helping small businesses acquire credit.
Though all lenders have their own rules, regulations and procedures, the basic concept is always essentially the same: to act as an intermediary between individuals who want to borrow and those happy to lend their money in exchange for a return.
How Is Peer to Peer Lending Different to Traditional Banking?
Of course, the above description of peer to peer lending could also be used to describe the function of a traditional bank, whereby savers place their money in the coffers of the institution who then invest it and share out the returns amongst their customers in the form of interest.
The key difference between peer to peer lending and regular banking is that, with a peer to lender, the money being raised and lent out is not the responsibility of the company arranging the loan. They take a fee for making the arrangement, but do not actually take charge of the money in the same way that a bank does.
This means that they do not have to guarantee deposits for investors and savers and, by the same token, they do not need to worry about the possibility that those receiving the funds might default on their repayments. As they are in a less risky position and have lower operating costs than a bank, they are generally able to offer considerably better returns. For example, Zopa currently offer savers 5.1% or higher whilst most high street banks deem 2% or lower to be competitive.
These higher returns do not come at the expense of borrowers however. Indeed, they also benefit from cheaper rates than are easily available elsewhere. Though the difference is not quite so marked, a loan from a peer to peer lender will generally be cheaper to repay than an equivalent from a bank.
What Are The Risks?
As stated above, the main reason peer to peer lenders are able to offer such good rates to borrowers and savers alike is that they do not offer the same assurances as banks. Such companies are not backed by the Financial Services Compensation Scheme which can help those who lose money to banks that fail.
That said, peer to peer lending is far from an unregulated free for all. Indeed, peer to peer lending services have such stringent controls over how savers’ money is lent out that the biggest names in the field actually have a lower default rate (around 0.5%) than the major banks, with between 75-90% of loan applications turned down on the basis of credit checks and affordability tests.
Moreover, lenders have various other ways of minimising the risk posed to borrowers. For example, they may ensure that your money is split between a high number of lenders (for Zopa it’s at least 50, and no one borrower ever has more than £10 of any single lender’s money) as a provision against any one of them failing to pay back the loan.
In addition, unlike with a bank where savers have no say on how their money is invested, with many peer to peer lenders you are able to choose exactly what sort of borrowers you are happy to give money to according the category of risk they present according to the lender’s assessment. This gives you the option to diversify your investment by spreading your money across different ‘markets’ or risk categories, just as you might with a portfolio of stocks and shares.
Others, such as RateSetter, don’t offer such control but instead allow lenders to make a small contribution to their ‘provision fund’ which is kept in reserve to compensate savers should their money be lost. Though this isn’t legally guaranteed, it has ensured that to date all savers have got back the money have lent, and the interest owed them, in full.
It is worth noting that when your money is waiting to find a lender it will usually be held in a ring-fenced account with a bank and will therefore have protection from FSCS for that time, should the company go under. Furthermore, the big names of the industry have formed the peer-to-peer finance association, which sets out a code of conduct lenders should follow with regards to recovering saver’s money should something go wrong.
Whilst the measures the big peer to peer lenders use to manage risk appear to be highly effective, it’s important to remember that lending still entails some level of risk. As such it would be foolhardy place all you eggs in one basket, and you’d be well advised to use peer to peer lending in conjunction with other methods of saving where returns are absolutely guaranteed.
Whilst the rates on offer are better than those to be had from the average savings account, in some ways the comparison is a little unfair. Whilst the majority of savings accounts allow you to take your money out without any sort of notice period, getting your money out an account with a peer to peer lender can be slightly more convoluted.
In most cases you will choose how long you want your money (or a particular portion) to be locked away for by deciding how long term a loan you’re willing to back. As with a product such as a high interest bond, the longer you’re willing to leave your money in the hands of others the better the rate you’ll be offered.
If you want to access your cash before it’s due to be repaid you can, depending on the service, sell off the debt to somebody else happy to lend on the same terms as you had been. However, there’s usually a charge in the region of around 1% of the sale for this and there may be other restrictions.
That said, Funding Circle (who allocate saver’s money to small businesses) claim that on average a buyer is found for an up for sale loan within half an hour and that funds from sale are usually released within two days.