Peer to peer lending growth

The origins of peer to peer lending

In the UK central bank interest rates are at an historic low of 0.25%. Across the western world central bank lending rates are at historic lows and in Japan and the Eurozone rates are even negative (meaning that individuals have to pay to keep their money in a bank).

In the UK rates have been at historic lows since 2009. The low interest environment has meant that savers have struggled to find decent returns in this low yield world. Banks are offering virtually zero interest on charging to hold large deposits. There appears to be no traction in the bond market either. Options appear to be running out for the traditionally safe investor.

For those investors willing to take on additional risk they have moved into riskier asset classes where possible such as property, stocks, funds and structured products in an effort to seek higher returns. But what do you do if you aren't willing to invest in such risky asset classes?

The need for more straightforward assets in which to invest has seen the rise in a relatively new asset class - peer to peer lending.

What is peer to peer lending?

Peer to peer lending is a platform where savers meet borrowers and transact without the need for a big bank acting as middle man and taking a large commission for the privilege. In theory peer to peer lending is a bit like having you money in a bank as you receive regular interest for your investment. 

To make this a bit clearer think about how a bank makes money. Banks take in savings from individuals by offering to pay a small percentage of interest. Banks then take the money and lend it out to businesses or individuals looking to borrow money and charge them a higher interest. The banks profit is the difference between the interest income from the money lent out versus the interest expense paid to people who have saved with the bank.

Peer to peer lending removed the bank as the middle man. As a saver using a peer to peer lending platform you are lending directly to those businesses who require funding. The platform take a cut of your earnings, generally as a percentage point of the interest. To make this a bit clearer: if you lend to a business at 8% then you will lose one of those eight percentage points in fees leaving you with 7% in interest income. Despite this seemingly high fee you can easily achieve very high rates of return far in excess of those achieved by saving your money in a bank. Currently rates are between 4% all the way up to 15% interest return depending on the level of risk in the business that you lend to.

Peer to peer lending can be risky

There are risks however and these risks are more than should you stick your money in a bank. If one of the businesses that you've lent to goes bust then it is likely that you will lose some if not all of your money. Peer to peer lending platforms recognise this risk. They help lenders by giving a risk rating to each of the potential borrowers. This means that could could choose to lend only to those businesses considered low risk, in which case your returns will be lower. If you choose to accept more risk and invest in those businesses given a lower creditworthiness by the platform then you'll likely receive higher interest assuming that the business doesn't go bust.

Strategy to minimise risk in peer to peer lending

The obvious solution is to only invest in those businesses considered low risk by the platform. The result being that whilst you're less likely to lose money, your returns will be lower. 

An alternative solution is to divide your money up into many mini-loans and spread those across a wide range of risky and non-risky businesses. You are effectively accepting that some of the riskier businesses will lose money but others will pay handsomely. You'll end up with an average return that's higher than had you simply invested in the low risk businesses.

Regulation in peer to peer lending

Currently money in a peer to peer lender is taxed under income tax. However it is thought that given the previlance of peer to peer there may be scope for use of ISAs in the future, sheltering your returns from tax. Watch this space!

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