How does peer-to-peer lending work?

Esther Shaw / 29 January 2016

Peer-to-peer lending offers affordable credit to borrowers and can give investors better returns than high street banks. How does it work?

Peer-to-peer (P2P) lending has taken off in recent years, with many savers seeing platforms, such as Zopa and RateSetter, as a better home for their hard-earned cash than ordinary savings accounts – and a way to beat the low returns available on the high street.

At the same time, more and more borrowers are viewing the sites as a way to get credit at an affordable level.

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When the sites first sprung up in 2005, people were unsure what to make of them.

A decade later, these platforms are firmly established; in fact, Zopa has now lent more than £1 billion, while RateSetter recently broke through the £800,000 million barrier.

How do the sites work?

Online platforms all match up ordinary savers who are willing to lend out spare cash with people who want to borrow money. With Funding Circle, savers supply loans to businesses.

As P2P effectively cuts out the middleman – by bypassing the banks – both lenders (savers) and borrowers should secure a better rate.

While P2P firms do take their cut, it is far less than the amount taken by banks and building societies.

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Lending through a P2P site

As a lender (saver), you can decide how much money you want to lend, and over what period of time.

You can start with a small amount, such as £10 and £100 until you get used to the way the site works.

Once you are happy, you can then look to build up the amount you lend.

You do not need to be super-rich to lend your savings via a P2P firm.

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Borrowing through a P2P site

As a borrower, you can request to borrow money, but will usually have to undergo a rigorous credit check before being accepted. 

Firms will only offer loans to people with good histories.

What rates are up for grabs?

Lenders (savers) can currently earn rates of up to 6%. This easily beats the rate paid on the best bank or building society accounts.

Note, however, that rates do fluctuate.

If you want to borrow money, Zopa is charging a rate of 7.5% on a loan of £3,000 at the moment, while Lending Works charges 7.0% on a loan of £3,000 over 36 months.

As Funding Circle is a P2P platform for business borrowers, the rates charged will vary and each application will be assessed on a case-by-case basis.

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Beware of the risks

While the rates paid to people who lend via one of these sites are higher than those paid by standard savings accounts, it is important to be aware of the risks.

P2P lenders are regulated by the Financial Conduct Authority (FCA), but money held with these firms is not protected under the Government’s Financial Services Compensation Scheme (FSCS).

This protects deposits of up to £75,000 if your bank or building society goes bust.

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Safety nets are in place

While P2P firms are not covered by the FSCS, most schemes do have some kind of “safety net” in place.

RateSetter, for example, operates a “provision fund” to help protect its lenders. This is made of up of fees charged to borrowers and is used to cover any late payments or defaults.

Zopa has always spread people’s money among many customers to minimise risk, and also runs a contingency pot to cover any losses.

Both Funding Circle and Lending Works also have safeguards to help prevent savers from losing their money.

So, while these established sites may not be risk-free, the default rate has, so far, been low.

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P2P and ISA allowances

From this April, the Government will allow savers to include P2P loans inside individual savings accounts (ISAs). This means you will be able to enjoy the interest tax-free.

This change is expected to trigger yet another flood of savers into P2P, finally bringing it into the mainstream.

Beware of new crowdfunding P2P sites

When looking at P2P sites, it’s important to differentiate established platforms from the new breed of “crowdfunding” P2P sites, as these often invest in highly risky start-up businesses.

Crowfunding is a way of raising finance by asking a large number of people each to invest a relatively small amount of money in a scheme, such as property or green energy.

Once again, there is no Government protection under the FSCS if disaster strikes, and the firm holding your money fails. But unlike sites such as Zopa or RateSetter, nor is there a “safety fund” to pay you.

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Tread carefully

Established P2P firms have a long track record of lending to individuals and businesses, and delivering returns to savers. But many of the new sites have neither track records nor recent accounts.

This makes it hard to know whether the business is viable in the long term. You need to be very wary before parting with any cash, and should not save money in P2P unless you understand how it will be used.

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The Peer-to-Peer Association

If you are not sure about a firm, it is worth checking to see if it is a member of the Peer-to-Peer Finance Association. Members – which include Zopa, RateSetter, Lending Works and Funding Circle – have all had to pass tough tests to join this trade body and are required to adhere to a strict set of rules.

For more tips and useful information, browse our money articles.

The opinions expressed are those of the author and are not held by Saga unless specifically stated.

The material is for general information only and does not constitute investment, tax, legal, medical or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.