The government has announced it is considering allowing peer-to-peer lending in a new individual savings account. Over the past couple of years we have seen an increase in enquiries on peer-to-peer lending as clients seek returns in excess of conventional cash deposit accounts.
What is peer-to-peer lending?
Peer-to-peer lending uses online technology to match private individuals to those wishing to borrow money. As explained below, some sites specialise in lending to other private individuals, but others focus on lending to businesses.
Who are the main firms offering peer-to-peer lending?
The first mainstream lending platform in the UK was Zopa, who were founded in 2005. Zopa offer lending by private individuals to private individuals, and at the time of writing have matched over £650 million peer-to-peer loans.
Funding Circle lend to businesses, and has presently lent around £400 million.
There are many other platforms available, and potential investors should do their own due diligence on the above, and the alternatives.
What are the benefits?
Put simply, higher potential rates of return. Investors are rewarded by putting some or all of their capital at risk, in favour of a greater headline interest rate.
What are the risks?
Peer-to-peer lending are not covered by the Financial Services Compensation Scheme (which covers up to £85,000 per person per institution on cash capital), and, despite comparisons to cash rates, peer-to-peer lending should be considered many times more risky. Investors can lose on individual loans if debtors default, and could lose their entire capital if the lending platform goes bust.
Some firms may be members of the industry group the P2PFA, but this is a voluntary body. It is a requirement for platforms to keep their customers’ funds segregated and is also good practice to offer some element of provision for default or ‘safeguard’ fund. All firms should be authorised and regulated by the Financial Conduct Authority. Not one of these provisions offers any formal protection, and may not dilute any of the risks detailed above.
We are concerned that many individuals use an historic basis of defaults to assess the future likelihood of further defaults. The past will not be a reliable guide to future and it is possible that systemic risks can exist that could cause a spiral of defaults, failure of one or more platforms in a ‘run on the bank’ situation.
Platforms varying degrees of due diligence on lenders, and most offer a structured way to chase defaults and bad debts. Nevertheless lenders interests are not aligned to those of the platform – lenders wish to mitigate risk and lend on appropriate terms, where the platform are paid based on the volume of loans that are matched, invariably regardless of the quality.
As peer-to-peer becomes more popular we would expect potential interest returns to fall, though not necessarily defaults. This would narrow the margin of benefit for investors.
More of a hassle than a risk, but as most platforms pay interest gross individuals would normally be required to file a tax return, even if not presently required. Tax advice may also be necessary where individuals look for relief on defaults, loans cancelled early and other circumstances.
What are the tax implications?
Most peer-to-peer lending will be treated as interest payments, with a liability of 20% for basic rate tax payers. Most firms currently pay this interest gross, unlike high street savings accounts and collective investments (“mutual funds”).
Current rates of tax on interest will vary depending on investor circumstances from 0-10-20-45-60%.
It should be considered a 6% gross interest payment for a basic rate tax payer is equivalent to 4.8% tax-free interest payment in an ISA. With a married couple able to put £60,000 into an ISA over the next six months this should often be the first investment made. A well diversified investment portfolio would typically need to expose an investor to a lower level of investment risk, to realistically achieve this 4.8% return.
Conclusions
Peer-to-peer lending offers a valuable alternative source of borrowing to the banks, who remain resistant to lending to many, particularly small businesses. However we are concerned that many individuals are seeking to use peer-to-peer lending as an alternative to deposits, quite unaware of the risks.
Peer-to-peer lending should never be considered an alternative to a prudent level of emergency funds, and those who are able to put capital at risk may be better served by using ISA allowances and spreading their investments across a diverse range of investment types.
