Investing in Peer to Peer Lending

Peer to peer lending directly connects investors with borrowers via a peer to peer lending platform.

Peer to peer lending platforms aim to provide value to all parties involved. The investor has the opportunity to generate enhanced returns vs. saving cash in banks or other financial institutions. Borrowers benefits from loan capital at competitive interest rates which can be used to fund growth. Meanwhile, the peer to peer lending platform itself generates profit from facilitating this arrangement.

There are many UK-based platforms, with each tending to specialise in one type of lending: consumer loans, property-backed loans or business loans.

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How does peer to peer lending work?

Investors in peer to peer lending effectively take ownership of a fraction of a much bigger loan.

Peer to peer lending platforms source, risk assess and administrate the loan, generally earning fees for providing the loan along with a margin on the interest charged (i.e. the difference between the borrower interest rate and the interest rate peer to peer investors are paid). The borrower pays the platform directly and the platform disperses those funds to lenders.

Why do borrowers lend from peer to peer lending platforms?

Peer to peer lending platforms are simply an alternative choice for borrowers. They are often in competition for lending but may be chosen due to (i) speed of application process, (ii) lower interest rates, and/or (iii) willingness to lend.

Typically peer to peer lending thrives in parts of the market which are less ‘vanilla’. For example, there are no peer to peer lending platforms operating in the buy-to-let lending market, but there are several offering development/bridging loans.

Things to consider before investing in peer to peer lending

There are a number of things you should consider prior to investing and when comparing various peer to peer lending platforms:

  1. Track record of platform – Does the platform have a strong reputation, or is it known for making poor lending decisions? If a business is known for making poor credit decisions then it does not bode well for future returns.
  2. Interest rate – What is the interest rate? Is that rate sufficient for the level of risk?
  3. Nature of lending and lending criteria – Type of loan (consumer, property, business), loan-to-value (LTV) requirements, unsecured vs. secured lending, individuals or companies, size of loans
  4. Security and seniority of debt – What is the type of security (property, other assets, personal goods, director guarantee)? If loans are secured, are they first or second charge? What loan-to-value or loan-to-development value?
  5. Repayment profile – Will the business repay capital and interest throughout the loan term or purely at the end of the loan? What payments will the platform make to you?
  6. Ability to exit – Is there a secondary market available to resell loan holdings?  If so, is there a track record of demand? Are there any fees for selling loans? Does the secondary market enable discounting?
  7. Loan term – Given secondary market availability is not guaranteed, what are the underlying loan terms? Are you comfortable with not having access to your cash for this period of time or longer? Are the types of loans offered prone to delay (e.g. development loans)?
  8. Availability of IFISA – Does the platform offer a tax-free Alternative Finance ISA?
  9. Self-select vs. auto-invest – Does the platform allow you to pick which investments you want to be exposed to, or does it purely offer ‘black box’ lending? Do you have the time to conduct due diligence when self-selecting your investments?
  10. Provision fund – Does the platform have a provision fund? What is the policy in regards to how that provision fund is utilised?
  11. Skin in the game – Does the platform co-invest in its loans alongside investors?  If so, what proportion of the loans are held by the platform?

Key risks associated with peer to peer lending

The main risks of investing in peer to peer lending are:

Poor asset allocation decisions

Diversification is key when investing in peer to peer lending. If you invest £1,000 in peer to peer lending split across two loans, you could lose 50% of your capital if one of those were to default. If you invest £1,000 across one hundred loans, the most you could lose from any one default would be £10 (1%).

As well as diversification, it’s important to avoid getting greedy when comparing peer to peer lending returns. If one platform or loan offers a higher rate of interest than another, there will be a reason. The interest rates offered by platforms are typically the rate being paid by the borrower plus a profit margin. Borrowers are not stupid and will seek the best value loan (just as you would when remortgaging your personal property). If a loan is offering high interest, it is because the market has considered the risk and priced it into the loan.

Credit risk (i.e. borrowers defaulting on loans)

Unsecured loans – Where the underlying loan is unsecured, there is no property that the lending platform can force the borrower to sell in the event of default. Legal action can be taken but this is often unsuccessful in recovering loan funds.  

Secured loans – Where the underlying loan is secured, the sale of the security is not guaranteed to recover loan capital. For example, a property loan may be offered to a developer who ultimately breaches planning permission and is ordered to knock down part of the building. In this scenario, the value of the property would be significantly reduced. Note that it is also possible for the credit control team to be wrong in their initial assessment of a property’s value.

A proportion of loans will always go bad, reemphasising the importance of diversification. Generally you would expect that the interest earned on performing loans will outweigh the capital loss suffered on any bad loans.

Unlike with saving your funds in a bank account, there is no governmental protection if funds are lost when investing in peer to peer loans.

Risk of the peer to peer lending platform going into administration

All peer to peer lending platforms are regulated by the FCA and are required to have funded wind-down procedures in place in case they go out of business. Where platforms go out of business, you retain your interest in the underlying loans. However, the ability to resell your loan holdings early would most likely end and it may take longer to receive your cash back whilst the appointed agent or administrator seeks to recover funds. If the wind-down process takes significantly longer and costs more than expected, it is possible that administrators begin to extract fees from loan repayments.

Platform risk can be reduced by (i) spreading investments across multiple platforms, (ii) picking platforms which have strong track records and financials.

How is peer to peer lending taxed?

Interest earned through peer to peer lending is taxed as normal interest income.

However, basic rate taxpayers pay no tax on the first £1,000 of interest, which decreases to £500 for higher rate taxpayers. Alternatively, if you save in an Alternative Finance ISA (‘IFISA’), no tax is payable to HMRC. It is possible to sign up for an IFISA in addition to having a Cash ISA, Stocks and Shares ISA, and/or Lifetime ISA in any given tax year, though you are subject to a combined limit of £20,000.

If a borrower defaults on a peer to peer loan, the loss can be offset against other peer to peer lending income, prior to taxation. Refer to HMRC’s guidance on peer to peer lending taxation for further information.

Getting started – Investing in peer to peer lending for the first time

It’s easy to start investing in peer to peer lending. Simply:

  1. Open an account with a peer to peer lender and deposit cash via debit card or bank transfer.
  2. Select underlying investments – either self-select loans or choose to auto-invest if an available option.
  3. Your cash will then be invested in underlying loan holdings. You will hold these until the borrower repays, unless the platform offers the ability to resell loan holdings in which case you may be able to exit your investment prior to the end of the loan term, subject to demand.

The below are some popular peer to peer lending platforms:

  • Kuflink – Secured bridging/development property loans.
  • Crowdproperty – Secured bridging/development property loans.
  • Loanpad – Secured bridging/development property loans, but offers a lower risk tranche of the loan, with a lending partner taking the higher risk tranche.
  • Assetz Capital – Secured business loans, with property/business assets as underlying security.
  • Lending Works – Unsecured consumer lending.

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