The number of P2P lending companies is growing. Is this a great way to grab the profit banks would otherwise make? Or might you end up struggling to beat a savings account?.
What is P2P lending?
The concept is really as simple as going into the pub and asking if anyone wants to borrow some money from you. The difference is, P2P lending uses the Internet (and not your local) to help you find willing borrowers. And there's a company in between to help vet potential borrowers and chase them if they don't repay your money.
Is it risky?
Like any type of lending, if a borrower doesn't pay you back then you'll lose that money. In this way P2P lending is more similar to corporate bonds than savings accounts. But, unlike corporate bonds, you'll know next to nothing about the person you're lending to, so P2P loan companies carry out credit checks to try and categorise the riskiness of each borrower.
If a borrower doesn't pay, the company arranging the transaction will normally chase the money on your behalf and seek to recover it via the courts if necessary. But if the cash isn't forthcoming you'll have to write it off as a bad debt - you won't be covered by the Financial Services Compensation Scheme as you are with savings held in a bank or building society.
P2P companies encourage you to split your money across a number of borrowers to reduce the impact of a specific borrower defaulting - some do this automatically. Nevertheless, depending on who you lend to, the risks can be high and trying to quantify these is one of the most important considerations when lending in this way.
What sort of return can you expect?
With typical headline rates of 8% or more, annual returns, on the surface, look very appealing. But you need to factor in fees charged by the P2P loan company and, more importantly, the impact bad debts might have. Based on estimates, annual returns net of bad debts and fees seem to be in the region of 5-7% before tax at the safer end of the scale. But bear in mind your return will ultimately depend on the actual level of bad debts.
How high might bad debts be?
How long is a piece of string? P2P loan companies usually publish estimated bad debt rates (if they don't be wary) but, as with any guesstimate, they might be wrong. Use their figures as a broad guide, but accept that the actual level could end up a lot higher or(if you're lucky) lower.
The trouble is, P2P lending is a relatively new concept so there's little past data on which to base expectations. The longest running company is Zopa and their bad debt estimates on 5 year loans taken out 2-3 years ago have, with hindsight, proved rather conservative.
| Percentage of loans that defaulted | |||||
|---|---|---|---|---|---|
| Borrower category | A* | A | B | C | Y |
| 5 year expected | 0.96% | 1.92% | 3.84% | 7.70% | 7.18% |
| 5 year actual# | 0.00% | 6.36% | 5.70% | 21.05% | 8.26% |
| Source: Zopa. # includes actual defaults and expected defaults from loans already in arrears. | |||||
These figures show the proportion of loans in default, so the impact on annual returns could be higher still. In fairness the default rates on Zopa loans issued within the last 2 years are generally within their estimates. But the above figures should still sound a warning: they reflect loans that have been through the credit crunch and the trend that defaults are more likely to occur in the latter half of a loan - arguably relevant given the current economic outlook.
Of course, the impact a bad debt has on your overall return depends on what proportion of your loan portfolio it represents and when it occurs. You'll lose more money from a loan that defaults early on than one later, when more of the loan will have already been repaid.
How long must you lend for?
Loan periods tend to be between 1 and 5 years, but vary between P2P loan companies (e.g. Ratesetter offers a rolling 1 month rate). Borrowers are often allowed to pay off the loan early, without penalty, reducing your potential return unless you can re-lend that money at a similar rate. If you want your money back sooner some P2P loan companies provide a marketplace to sell it on to other lenders, albeit for a fee. But in general you should be prepared to tie up the money for the duration of the loan - although as monthly repayments include some capital (unlike corporate bonds or savings) you'll gradually get access to the money over the loan period.
What's the tax position?
Any interest payments you receive are paid gross but subject to income tax. Unfortunately bad debts can't be offset against the interest, which is disappointing.
P2P loans can't be held within ISAs or pensions - a downside for taxpayers. So when comparing potential returns to other investments bear this in mind.
What happens if a P2P company goes bust?
As your contract is directly with borrowers they'll still owe you the money. And there should be provision for a third party company to take on the collection of the debt. But, if this happens, you can bet some borrowers will become more reluctant to repay the money so expect an increased risk of bad debts. As P2P lending is not currently regulated by the Financial Services Authority (FSA) your only protection will be via UK law.
So is P2P lending a good idea?
P2P lending is a great concept - why borrow from banks when we can cut out the middleman and borrow from each other? Trouble is, therein lies a potential problem. Banks can offer competitive loan rates by paying paltry average rates on their savings accounts - P2P lending is more transparent and relies on the rates demanded by lenders being competitive for borrowers. If there's a mis-match then there'll be more of one than the other - so you might face a long wait to lend or borrow at appealing rates.
I'm also wary that a difficult economic period could push up bad debts to the point returns for lenders lag a decent savings account or, worse still, lose you money overall. Of course, I may be wrong and returns turn out to be excellent thanks to minimal bad debts - but I suppose that's the point, none of us knows what will happen in future.
Overall I think P2P lending is worth considering, albeit with a healthy dose of cynicism over whether you'll actually enjoy a decent return (given the current economic outlook). Estimate a realistic worst case scenario and make sure the interest rate you can get (after fees) adequately compensates. If it doesn't then look for another home for your cash.
If you do decide to lend I'd suggest dipping your toes in the water with a small amount to start with. This will give you a feel for how the system works and if it goes wrong your losses will be limited.
Comparison
Below is a list of all the current UK P2P loan companies I could find. They're not paid links or recommendations, just a list you might find helpful.
| Company | Borrower type | Typical current annual returns (before fees & bad debts) | Annual fee | Estimated impact of bad debts on annual returns | Loan period |
|---|---|---|---|---|---|
| Funding Circle | Business | 7-9% | 1% | 0.6% - 2.3%* | 1 or 3 years |
| Quakle | Personal | 7% -25% | Nil | N/A | 1-3 years |
| Ratesetter | Personal | 4% (1 month) 7.8% (3 years) | 10% of interest received | N/A** | 1 month or 3 years |
| Yes Secure | Personal | 10% - 25% | 0.9% | 3% - 25%*** | 1-5 years |
| Zopa | Personal | 6.4% - 12.1% | 1% | 0.5% - 5.2% | 3 or 5 years |
| * Some loans backed by personal guarantees. ** Provision fund intended to reduce risk of bad debts. *** Actual default percentage, impact on annual returns could be higher. | |||||
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