P2P lending is a broad category that covers a variety of different investments. However, at the most basic level, all P2P loans are similar: you, the investor, deliver money to one or more businesses or individuals, who then pay interest on that money, returning the initial loan at the end of the term.
A P2P lending platform facilitates the loan, and they are responsible for collecting interest on your behalf on a monthly or quarterly basis. These loans are often secured by property, equipment, or personal guarantee.
Traditionally, small businesses and individuals would have gone to the bank for a loan, but over the last decade banks have become far more cautious about lending money. Small businesses have the option of either selling equity (to an angel investor, or through equity crowdfunding) or taking on debt (P2P lending). Many businesses choose P2P lending because they either can’t or won’t part with equity.
The different types of P2P lending vary significantly, so it is essential that you understand how they work and which you are investing in. The different types we’ll cover in this guide are:
- Account-Based Products – Your money is spread across loans to many businesses or individuals.
- Self-select Investments – You choose to lend to a specific
- Innovative Finance ISA – Your P2P loans are wrapped in an ISA.
- Corporate bonds – Loaning money to large, listed companies.
Some platforms also put bridging loans under the heading of P2P lending, but we define these as property crowdfunding. Take a look at our property crowdfunding guide for more information.
Because each of the P2P lending products is different, we’ll look at each in turn.
Should You Invest in Account-Based Products?
Account-based products spread your money across loans to hundreds of business or individuals, so they’re heavily diversified. These products are advertised in a way that can make them look like a savings product, but they’re not – they’re an investment, and as with any investment, there is always an element of risk.
Typically, platforms offer 3 or 4 different packages, for example, a 1-year account might offer 3.40% gross, while a 5-year account could see you receive a larger return, say 4.80% gross. In return for the higher rate, you’re investing for longer. Some accounts offer as much as 6 or 7%, but the increased return reflects your increased risk – these accounts package higher-risk loans.
Advantage – Low Risk, Excellent Reputation
The reputation of account-based products is extremely good. Many of the bigger platforms can genuinely claim that none of their investors have lost money (because they cover the cost if investments fail).
That’s because of money they put aside, called a provision fund: when the platform receives money from fees, it puts some of it aside into a fund which is then used to pay back investors when a loan defaults. Even if the provision fund was not available, you’d still be offered some protection because of your low exposure to any one company or individual – the account-based products are highly diversified.
Advantage – Good Potential Returns
Considering their reputation, high level of credibility, and good track record for low risk, the investments could provide a good potential return; the 4-7% you receive is significantly higher than you’d receive from a savings account.
Disadvantage – Fees Apply To Exit Early
Some platforms don’t give you the option to exit early, and those that do often charge a fee for you to do so. Often you can only exit if the platform can find other investors to take over your share of the loan. It is best to invest when you are sure you won’t need to exit during the minimum duration of the loan.
Should You Invest in Lending Directly To A Specific Business?
Loaning direct via self-select works in a similar way to an account-based product, except you choose which business you invest in. You are provided with information about the business, and what they’d like to use the money for, and make your decision from there; the platform facilitates the loan for you.
The businesses you are lending to tend to be very small, so you’re fully exposed with no diversity (unless you choose to invest in multiple businesses or other types of investment). For this reason, these loans are only to people who are very financially literate, can read and understand business documents, and are confident in taking a risk.
Advantage – Investing In A Business You’ve Chosen
Unlike account-based loans, investing directly in a business allows you to compare and choose from several businesses. If you’re confident that you can pick out good investments where the return outweighs the risk, this could be a profitable investment.
Advantage – Very High Potential Returns
These loans have the potential to provide a high potential return, and can even be up to 20%. They are often quite short, typically lasting for 12 months, so you can potentially receive your initial loan back quite quickly (unless the business fails).
Disadvantage – Very High Risk
That potential high return is offered because you are investing in small businesses with a very high risk. It is highly likely that you could experience some failure if you invest in these products.
Should You Invest In An Innovative Finance ISA (IFISA)?
The Innovative Finance ISA, or IFISA, is a new tax wrapper introduced in April 2016. It is not a product itself, just a wrapper for P2P loans. Platforms are just starting to introduce products using this ISA now.
Advantage – Tax Efficient
Normally, interest received through P2P lending is added to your taxable income and taxed accordingly. The IFISA wraps up your P2P lending in a tax-free bubble, so any interest you receive is tax-free. For example, an investment of £2,000 in P2P loans returns you 10% (£200). If you are a higher rate taxpayer, 40% of this (£80) will go to the government. The IFISA saves you this money, allowing you to reinvest more and get a bigger benefit from compound interest.
Disadvantage – No FSCS Guarantee
Cash ISAs are protected by the Financial Services Compensation Scheme, which means they are underwritten by the Government up to a value of £75,000. P2P lending is not governed by the FSCS and so does not benefit from this guarantee.
Should You Invest in Corporate Bonds?
Corporate bonds are sold for listed businesses. You agree to lend them the value of the bond, and in return, they pay interest (normally annually) on that loan. At the end of the agreed period, the loan is repaid in full.
In addition to corporate bonds, you may also see government bonds or alternative bonds. Government bonds involve lending to the government and offer a low return but are also low risk (the chance of the government going bankrupt is considerably less than the chance of a business going bankrupt).
Alternative bonds, such as ‘socially responsible’ green bonds that are secured on alternative energies, such as wind or solar farms may appeal to some investors if supporting alternative energy is something you are passionate about.
Advantage – Relatively Low Risk
Bonds tend to be considered lower risk for two reasons.
Firstly, the businesses issuing them are large, established companies. This does not mean they can’t fail, but the amount of public information available about these businesses does mean you can make your own assessment. Typically, if a business this size is in trouble, you’ll be able to find out about it.
Secondly, in the event of bankruptcy, bondholders are paid before shareholders, which makes a bond a safer investment than shares in the same company. However, the company must first settle with other creditors, including banks, so this doesn’t mean you’ll see your money back.
Advantage – Good Potential Return
Corporate bonds can typically provide a return of around 6% gross interest per annum, although the potential return varies depending on the business. Considering the comparatively low-risk nature of the bonds, this is a good return in comparison to a (currently very low interest) savings account. Some bonds in smaller companies offer higher returns, but of course this comes with increased risk.
Need to Know – Gross or Net
Some platforms list the interest you receive as gross, and some as net. Gross interest is the total amount before deductions, while net is the total after deductions. You must keep this in mind when comparing two different investment opportunities as one may look superior only because it is showing gross interest and the other shows net interest – you may need to get your calculator out to check the real comparison price.
Need to Know – Understanding How Your Loan Is Secured
Your loan can be secured in one of several ways:
- Business Assets – Securing on machinery or equipment owned by the business.
- Business Invoices – Securing against future promised payments and invoices.
- Debenture – A written agreement filed with Companies House which specifies that in the event of insolvency, your loan must be paid off before unsecured creditors (VAT, PAYE, trade creditors).
- Land Charge – Secured on land (somewhat like a mortgage for a property).
- Mortgages – The platform owns the mortgage and sells it in the form of bonds to investors.
- Personal Guarantee – Unsecured written agreement from an individual to pay the loan. For example, a business owner may make a personal guarantee on a loan to his business.
- Property – Debt is secured on property owned by the business or individual
What is important to remember is that not all securities are made equal. Typically, business assets and property are more favoured by investors than personal guarantees, but it depends on the situation. If the person guaranteeing the loan has a high net worth or is highly motivated to avoid bankruptcy, this could be a good choice. You must judge for yourself whether the risk for the loan and what it is secured on, are worth the interest you will receive from investing.
Questions to Ask Yourself Before Investing in P2P Lending
Any and all P2P investments are a risk, even those we’ve labelled as relatively safe. Considering the varied nature of the different P2P investments, it is especially important that you understand what you’re investing in. You may want to ask yourself the following questions:
- Can I afford to lose my investment (always ask this before making any investment)?
- Do I understand the risk level of the type of P2P lending I am interested in?
- Have I lowered my risk by diversifying my investments?
- Are you happy to invest your money for the full duration of the loan?
- What is the loan secured on?
- Is a provision fund available?
- Is the listed interest gross or net?
- How is the business secured?
Getting Started With Your First P2P Lending Investment
Even when you understand the type of investment, you’ll still want to some additional research, especially for your first investment. You might want to research:
- The track record of the platform (especially in the case of packaged products).
- For specific lending and bonds, you’ll want as much information as you can get:
- The business’s track record.
- The experience of the board of directors
- The product they produce, and its place in the market.
- The company’s revenues and forecast.
- How the business has calculated their valuation.
- How the business will use the funds you provide.
You may also want to get advice from a financial advisor about if you should use an Innovative Finance ISA.
Please head over to the OFF3R Peer to Peer Lending channel to compare the latest opportunities.
Risk Warning: Investing in or lending to early stage businesses involves a high level of risk, including illiquidity (inability to sell assets quickly or without substantial loss in value), lack of dividends, loss of capital and dilution risks and it should be done only as part of a diversified portfolio. Tax treatment depends on the individual circumstances of each investor and may be subject to change in the future. Your capital is at risk.