Peer to Peer Lending

Introduction

What is Peer to Peer Lending?

Peer to Peer lending is a rapidly-growing form of alternative saving (capital is at risk). Peer to Peer lending platforms cut out the middle man, allowing individuals and companies to borrow money from lenders directly. As an investor, you lend money to people and businesses who are looking for loans – and over time, they pay back to you both your original savings amount plus interest.

The risk to your capital associated with an individual borrower defaulting can be reduced by diversifying your loan book across a large number of borrowers – many of the Peer to Peer lending platforms do this automatically, meaning that if one borrower should miss a payment date, only a small fraction of your funds are at risk.

Should I lend money through Peer to Peer lending?

The decision is down to you. Certainly there are higher interest rates available – however, each prospective lender should decide for themselves whether they are comfortable with the additional risk over and above a bank or building society savings account.

On top of this, some of the larger Peer to Peer lending platforms operate Reserve Funds – designed to cover your lent funds (plus interest) in the event that one of your borrowers were to default. However, these Reserve Funds are not guaranteed and capital is still at risk.

You can find out more about your expected returns using the tax savings calculator here.

The website also provides a list of the available peer-to-peer lending ISAs.

Types of Peer-to-Peer Lending

1. SME business lending

This form of peer-to-peer lending advances small loans to established trading businesses, usually Limited Companies.

Loans may be unsecured but may also be secured against the company’s assets (perhaps a property, stock or against its customers’ future payments). There may also be a personal guarantee provided by either the company’s Directors, its shareholders, or both.

SME peer-to-peer loans are typically used to finance ongoing trade (also known as ‘working capital’), business expansion or the acquisition of new assets (such as equipment or vehicles).

2. Property lending

Peer-to-peer property loans are made either to developers or investors, both of whom may take the form of individual borrowers or Limited Companies.

These loans are typically supported by a first legal charge over the underlying property, meaning that in the event that the borrower fails to meet their repayment obligations, the property may be repossessed and sold on in order to redeem the loan.

This form of peer-to-peer lending can be used for personal mortgages, buy-to-let properties, residential property refurbishment as well as commercial loans.

3. Consumer lending

This form of peer-to-peer lending typically covers smaller, unsecured loans that are made to individual borrowers rather than to businesses.

Loans in this sector are typically used either to fund purchases (weddings, holidays, home improvements, etc) or to consolidate existing debt.

Risk considerations

Is Peer to Peer lending covered by the Financial Services Compensation Scheme (FSCS)?

What is the FSCS?

The Financial Service Compensation Scheme (FSCS) is the UK’s state compensation system for those who have savings or deposits with certain authorised financial services firms.

The FSCS exists to pay compensation to savers in the event that an authorised firm within the scheme is either unable or unlikely to be able to pay back to savers the money that they have deposited with it.

The FSCS is not a bank-run system, but rather a totally independent body which is funded by a statutory levy (fee) paid by member firms.

The FSCS has a wider remit than many savers believe; the scheme not only covers certain forms of bank savings accounts but also (amongst others) covers insurance policies, certain investments, and mortgages.

History of the FSCS

The scheme was introduced shortly after the new millennium and was intended to replace the plethora of other compensation schemes which had existed previously.

There have been several notable payouts to savers, and several situations whereby the FSCS has stepped in to underwrite financial institutions who have either been unable to, or who were clearly approaching a position where they were unlikely to be able to, service their obligations to borrowers – notably Bradford and Bingley in the wake of the 2008 financial crisis.

Claim Limits

In terms of bank savings deposits, the maximum compensation that any individual saver is eligible for is (from 1st January 2016) £75,000 per person per firm. That is to say that an individual saver may spread a £150,000 savings balance across multiple banking institutions in order to spread the risk – i.e. two £75,000 accounts with unrelated institutions.

4 September 2012

In September 2012 the Financial Services Compensation Scheme announced that it had met with some of the larger Peer to Peer lending platforms, confirming that, whilst the FSCS does not cover Peer to Peer lending, if the Peer to Peer lending site holds the lender’s money in a client account opened with an FSA-authorised bank or building society, the FSCS would indeed cover the investor up to the maximum claim limit (repayable within seven days)

The bottom line

Whilst Peer to Peer lending is tightly governed by the FCA and can deliver excellent returns compared to a regular bank or building society savings account, it is very important that prospective Peer to Peer lenders understand that, unlike regular UK bank or building society savings accounts, Peer to Peer lending is not presently covered by the Financial Services Compensation Scheme.

Planning for Every Potential Outcome

In recognition of the fact that the Peer to Peer lending sector is not currently covered by the FSCS, many platforms operate Reserve Funds which are put in place internally within the Peer to Peer lending platform to compensate lenders in the event that a borrower is unable to meet their loan repayment obligations.

The specific mechanics of how each Peer to Peer platform’s Reserve Fund works is covered in greater detail elsewhere within the Innovative Finance ISA website, however in general terms, most tend to retain a proportion of their fee and margin income in order to offset any potential future repayment arrears and defaults. In effect, if and when a borrower were to default on a loan repayment (either in part or in full), a claim will be generated internally within the platform and the Reserve Fund will be called upon for any outstanding interest and capital repayment.

It is worth noting however that these Reserve Funds are not currently regulated and are in effect operated on a discretionary platform-by-platform basis. The ability for that Reserve Fund to cover any amount(s) outstanding on defaulted loans is not guaranteed.

How P2P Lending helps British businesses

Britain's growth engine

SMEs are all too often relied upon as Britain’s economic growth engine – yet the traditional high street banks’ reluctance to provide lending facilities is well documented.

8 years of neglect

Figures published by the Bank of England show that total loans extended to SMEs fell in the first 3 months of 2014. “Net” loans to SME businesses, which measures total new SME loans less existing SME loans repaid, fell by almost £750 million between January and March of that year.

Fast forward a year, and the position has improved slightly. Lending to SME business grew during the year to October 2015 – the first time we have seen lending growth in four consecutive quarters since before the global recession of 2008.

Peer-to-Peer lending - a vital bridge to SMEs

The Innovative Finance ISA has been launched by the UK Government as part of a wider effort to nurture and support the continued growth of the UK’s peer-to-peer lending sector. Peer-to-peer lending is providing a relatively small, but rapidly growing and increasingly important source of funding for the UK’s 5.2 million Small and Medium sized businesses (commonly known as SME businesses).

Peer-to-peer lending, which is also known by its abbreviated name, P2P lending, is an increasingly popular form of lending in which investors can lend their cash to suitably appropriate SME businesses via an online matchmaking platform.

Lenders’ cash can be lent out to all manner of borrowers, at all manner of rates and using all manner of security measures – depending on the lender’s risk appetite, and his or her target return rate. Lenders can choose to lend either to individuals or to businesses, and can focus their cash on any number of borrowers – from single borrowers through to many thousands of borrowers.

The peer to peer lending system is growing exponentially, because it allows people with money to lend it directly to vetted borrowers – cutting out the banks who, middlemen for countless generations, have taken hefty fees from both borrower and lender.

Peer-to-peer eliminates the middleman, improving efficiency and removing some of what is lost between the rate paid by the borrower and the rate received by the lender

Peer-to-Peer lending Vs. Equity Crowdfunding

Two types of crowdfunding - a world apart

The continued growth in both debt-based and equity-based crowdfunding has generated ever-increasing intention within both the financial and mainstream popular press.

However, it is still the case that the differences between the two major categories of crowdfunding – debt and equity – are not all that often well distinguished. The two categories of crowdfunding are distinctly separate, and yet many are confused into thinking that ‘lending to companies’ (debt-based crowdfunding) and ‘investing in companies’ (equity crowdfunding) are the same thing: this is not the case.

Both debt-based and equity-based crowdfunding rely heavily on the underlying security of the company:

Confusingly, some forms of debt instrument allow the lender to convert the debt into ordinary shares (i.e. equity) within the borrower – however the vast majority of debt instruments available within the peer-to-peer lending sector are straightforward interest-bearing repayment loans.

Risk

Peer-to-peer lending, a form of debt crowdfunding, can be very attractive for investors who are seeking a fixed return, without participating in share ownership, and in comparison to equity crowdfunding, peer-to-peer lending will typically make financial planning much easier.

Traditionally, peer-to-peer loans that have been secured against the borrowing company’s assets have been regarded as less risky – and therefore there is less opportunity to achieve higher interest returns in comparison to an unsecured loan.

Peer-to-peer lending, whether taking the form of secured or unsecured loans, is inherently riskier than saving with a bank or building society savings account. This is because despite ongoing efforts within the industry to ensure borrower creditworthiness, and despite ever-tightening regulation by the Financial Conduct Authority, the sector is not currently covered by the Financial Services Compensation Scheme.