What is peer-to-peer lending?

So what is peer-to-peer lending?

It works on the principle that both lenders and borrowers will benefit from sidestepping the banks, because lenders will receive a higher rate of interest than they would from a savings account savings account and borrowers will pay a lower rate of interest than they would when borrowing from a traditional lender.

Between lender and borrower is an online intermediary who brings the two parties together and takes a small cut from each, generally a percentage of the interest paid to the lender and a flat one-off fee from the borrower.

Borrowers say how much money they need and then they set the interest rate they’re happy to pay. Savers say how much money they want to invest and then they set the interest they’re happy to receive and the online intermediary matches them up.

The key is for both parties to keep a sense of perspective and be realistic - borrower who thinks they can borrow for 2% APR is as self-delusional as a lender who thinks they can get a return of 20% APR.

The P2P lenders

Although P2P lending was highlighted during the “credit crunch” of 2008 when the banks began to get very choosy about whom they would lend money to, the concept is not a new one. The first P2P lender to launch in the UK was Zopa (www.zopa.com) in March 2005.

Since then, yes-secure.com launched in June 2010 and Quakle and Ratesetter were both launched in October the same year.

There are even P2P lenders that lend exclusively to small businesses, such as ThinCats and Funding Circle.

So how does P2P work?

While individual P2P lenders differ slightly from one another in the deals they offer, lenders and how they evaluate borrowers, the broad principle behind P2P holds true for all of them.

First off, the P2P intermediary is not a bank but a “facilitator” that gets lenders together with borrowers. Lenders say how much money they want to invest and set the interest they’re happy to receive. Borrowers say how much money they need and set the interest rate they’re happy to pay. The P2P intermediary matches them up and takes a cut.

Borrowers are credit checked (via a credit referencing agency such as Equifax and Experian) as if they had applied for a loan with a mainstream lender. The P2P company then credit scores applicants to see how big a risk they are and assign potential borrowers with a “grade”, usually from “A” to “E” with “A” being the most creditworthy and “E” denoting higher risk borrowers.

Lenders are invited to choose which type of borrower they want to lend to and how long they want the loan to be. In each category there will be a range of rates displayed and lenders then set the return they want to earn on their money.

Borrowers consider the rates offered to them and apply for the ones they like the look of. What follows is a sort of auction where borrowers “bid” for the rate they want to pay, with the lower rates often allocated to the more creditworthy borrowers (the A’s) while the less credit worthy will be offered higher rates. Lenders seeking a higher than average returns have to accept that these rates will almost certainly be paid by the highest risk borrowers.

Lenders can commit to lend any sum from £500 up to a maximum of £25,000 for as long as they wish. If lenders want to lend over this limit, they have to apply for and be granted a Consumer Credit License from the Office of Fair Trading (OFT), although in order to get such chunky amounts onto their network, the P2P company would probably do all the legwork for you.

As lenders’ money is distributed to a large number of borrowers, most P2P companies “auto lend”. This feature ensures that any money transferred into your account with the P2P company or any payments you receive from your borrowers are automatically recycled and reoffered in the company’s markets, so the money is always generating a return.

As all the P2P companies are quick to point out, while conventional bank loans charge an average APR of 12.7%, the average P2P loan rate is 8%. And with savers looking at an average return of 3.5% and the current UK inflation rate standing at 4.5%, an average rate of return on lending money via P2P at 8% means the lender gets one over on the banks and the Bank of England. And no banker gets a bonus.

What are the risks involved?

The overarching aspect to emphasise with P2P online lending is that it is not regulated by the Financial Services Authority (FSA) and this means there is no access to the Financial Services Compensation Scheme should anything go wrong.

That said, arguably the thought uppermost in a lender’s mind will be the likelihood of the borrower either defaulting on repayments or else absconding with the money once it’s been advanced.

The P2P companies have already anticipated this and reduce risk to the lender in a number of ways. First are the credit checks they run on every borrower. To reduce any risk, lenders only lend small chunks to individual borrowers. For example, at Zopa, a lender committing £500 or more would have their money spread across at least 50 separate borrowers.

Borrowers enter into legally binding contracts with their lenders and, in the case of a default, a professional debt collection agency would step in and pursue the loan, just as a mainstream bank would do.

Perhaps because of the unregulated nature of the market, P2P companies publish their default rates, which is not something mainstream banks do as a matter of course. Zopa says its default rate is 0.7%; Ratesetter says it has experienced zero defaults but factors in a default rate of 1.4%. Quakle says that for A and B-rated borrowers it is anticipating a default rate below 1%; for C and D-rated borrowers less than 3%.

How much does it cost to borrow and lend?

There’s no such thing as a free lunch and P2P borrowing and lending is no exception. Borrowers are certainly charged a fee and most P2P companies charge lenders a percentage of the interest they receive, but how the fees are levied changes from provider to provider.

Zopa charges lenders a 1% annual service fee and borrowers a flat fee of £130 once the loan is approved. Ratesetter charges lenders 10% of the interest they receive and borrowers pay a flat fee of £115. With yes-secure.com, the fee paid by lenders is 0.9% and borrowers pay an £80 flat fee; however, Quarkle charges lenders nothing but charges borrowers a fee of 1.5% of loan value once it's agreed.

Final points to bear in mind

Just because the sector is new, slightly unorthodox and unregulated, borrowers should not think that it’s a soft touch - P2P companies say their vetting procedure for potential borrowers is more stringent than high street banks - but successful applicants with good credit ratings will get access to loans at rates 40% cheaper than mainstream lending outlets.

Although lending to borrowers via a P2P company seems risky - especially as this sector of the market isn’t regulated by the FSA - the risk is mitigated by a lender’s cash being distributed amongst lots of borrowers. The reward for the risk is a much higher rate of return than a savings account.

The other point to bear in mind for borrowers is the taxman. All returns are paid without any tax - even basic rate - deducted, so you should declare your gains to HMRC. P2P companies make annual income statements available online to lenders at the end of the tax year showing the total gross interest they've received over the previous 12 months.

If you’re a taxpayer, this income should be declared to HMRC either directly to your designated tax office or through your self-assessment form.