3 things you should know before introducing P2P lending to your investment portfolio
You’ve no doubt put a lot of thought and effort into your current investment portfolio but, with the alternative finance market growing, it may be time to diversify further with peer-to-peer (P2P) lending. Here, the team at Lending Works explains what you’ll need to know about introducing this type of investment to your portfolio.
It’s no secret that the alternative finance market is growing, with online marketplaces providing the opportunity for companies and individuals to get finance in situations where traditional banks may refuse to. And, one alternative that’s leading the change is peer-to-peer lending, which now holds the biggest share of the market (University of Cambridge).
This type of lending holds a focus on connecting investors who are looking for a return on their money with borrowers that need a personal loan. Here, we will be explaining what P2P lending is and what you need to know before introducing it to your investment portfolio.
How does P2P lending work?
Peer-to-peer lending directly matches borrowers who are looking for a personal loan with investors who will charge an interest fee on the money they lend out. As P2P lending platforms are typically completely run online, they have lower overheads and tend to pass their savings onto investors in the form of interest.
If you’re looking to get started with P2P lending, there are three steps to follow:
- Open an account with a P2P lender and pay some money into it. Be aware that some platforms will have a minimum starting amount.
- Find a rate of interest that you’d like to receive on your money. These can be set by the lenders themselves who compete for the lowest rate on the reverse auction model — this is where sellers bid for the prices they are willing to sell their services at — or at a fixed rate set by the platform.
- Wait to be connected to a number of borrowers and lend a certain amount of money for a designated period of time e.g. 1 year or 5 years. It’s worth noting that some platforms will require you to pay a fee to lend money to their borrowers.
For borrowers looking to join a P2P lending platform, they will need to sign up and apply for a loan. Before this is granted, they’ll be credit checked and each platform will also have its own set of requirements to help them reduce risk as much as possible.
Once a borrower has passed these, they’ll be connected to a lender who they can request a loan from. The loan will come with an interest fee to pay. As a general guide, the higher risk a borrower is perceived to be, the more interest they may be required to pay you.
Is it risky?
Just like with any other form of investment, P2P lending does have its risks. There are three main ones:
The risk of default: This is the most obvious risk for investors trusting a borrower to pay them back. When they can’t, this is known as defaulting. Unlike when you take out a loan with a bank or building society, any money lent on P2P platforms is not covered by the Financial Services Compensation Scheme (FSCS). However, any good lending platform will have measures in place to lessen the impact should this happen. For example, we have a Lending Works Shield initiative, which provides first-loss cover, as well as automatic diversification.
The risk of late payments: There’s always a risk of borrower repayments being late, which could have a knock-on effect to your credit score if you’re relying on that money to cover bills and other expenses. However, some facilitators will have a reserve fund which can cover these late payments for the borrower, who will then have to reschedule their payment to the platform.
The risk of the P2P platform going out of business: Worst case scenario is the P2P platform may go out of business itself. However, all P2P facilitators in the UK are regulated by the Financial Conduct Authority, which means that their lenders’ money must be kept in accounts separate from the companies’. In addition, all P2P platforms should have an orderly wind down process in place should something go wrong. This can include back-up service providers who will take the responsibility for management, servicing and collection of any outstanding loans.
What are the advantages?
Despite the risks outlined above, there are plenty of advantages of adding P2P lending to your investment portfolio. These include:
Diversification of your investment portfolio: Spreading your money over a range of different investments can help you to minimise risk. This is because, with a portfolio of investments in different places, your funds are less likely to be affected by turbulence within the economy. It’s also worth noting that with P2P you’re typically encouraged to lend to multiple borrowers to spread the risk, therefore diversifying your investments further.
The platforms are regulated: As mentioned above, P2P lending platforms are regulated by the FCA, which can offer you peace of mind about your investments. For a lot of companies, this means that they have to offer a transparent service and be very open to giving advice to people using their service.
You can withdraw your funds whenever you want: P2P lending can be an attractive option if you need some extra flexibility. This type of investment means you can withdraw your funds whenever you want, given there is another investor to take over your role in the loans you wish to withdraw from. You can arrange for your P2P lending investments to give you a regular income, or you can set your money to be automatically reinvested each month.
The potential for lending to be tax-free: Money earned through P2P lending is typically classed as income and is therefore taxable. However, with the personal savings allowance set at £1,000 for standard taxpayers, there is the potential for the earnings to be tax-free. In addition to this, the recently released Innovative Finance ISA (IFISA) allows lenders to earn tax-free returns on their capital for up to the allowance of their individual ISA allowance per year.
The opportunity for ethical investments: More people are looking to make ethical decisions when it comes to handling their money and, due to the transparency offered by P2P lending, it’s considered to be a particularly ethical investment choice. Plus, with plenty of borrowers using the money to improve the quality of their lives, you may be able to help good causes.
Peer-to-peer lending is taking off in the alternative finance market so if you’re looking to make greater returns on your money in an ethical way, try it now.
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