Finance

An Introduction To Peer To Peer Lending

Rory 51 Comments , , , , , , , , , ,

Peer to peer lending (P2PL) is a relatively new investment venture that came onto the scene around 2005 when I was still sitting my high school exams. I first heard about it in 2011 but never really considered the possibility that it would become the third major investment class after stocks & shares and real estate.

What is it? Say one of your mates John wants to buy a new car and needs to borrow £3,000. He has the option of using his credit card but it charges in excess of 20% annual interest meaning he’d have to pay back £3,600 by the end of the first year alone.

Or he could ask his best friends you, Andy and Bob. The three of you chip in £1k each and John promises to pay everyone back in 2 years. For your efforts he’ll pay 5% annual interest. The three of you get back £1,100 each at the end of two years, John gets a new car and everyone is happy.

In essence this is what P2PL is all about – you act as the bank or credit card company to borrowers who are complete strangers. A middleman company (such as Zopa) facilitates this by linking the borrowers to investors. In reality, when you invest £1,000, your money is divided into £10 or £20 denominations, lent to 100 or 50 people respectively. Likewise, the person borrowing £1,000 is receiving £10 from 100 different investors. This lowers the risk of defaulted loans having a major effect on any individual investor and offers an internalised element of diversification.

Borrowers win because the interest is a fraction of what high street banks charge. Investors win because the return on investment (ROI) is several-fold higher than88 that of current interest rates. The middlemen companies also make money by charging a small fee to the investor or the borrower.

Aren’t you worried or suspicious they offer such high rates? The reason why banks charge ridiculous levels of interest is because they have numerous overhead costs such as maintaining their high street stores, paying for staff and expensive adverts. Even though companies like Zopa are also run by numerous staff they’re essentially just a website with far fewer expenses. They can therefore pass on this profit to investors, whilst charging borrowers less.

What kind of rates can you expect? The most famous P2PL middleman, Zopa, currently offers investors the opportunity to receive between 3.1% and 6.9% annual interest on their investments dependent on several factors. 6.9% is pretty impressive for 2017. You can go one step further if you’re willing to lend to businesses but they inherently carry a higher risk. Companies like Saving Stream allow you to finance development projects and property purchases with a headline 12% annual return or 1% every month!

Great, where can I sign up?! It hopefully goes without saying that when someone offers you a 12% return on your money in 2017 you need to ask yourself what’s the catch. As investors we’re forever pursuing that impressive ROI but simultaneously we need to avoid overly adventurous investments. Losing your initial £1k investment would be a disaster when you think about how many years of 12% interest you need to break even. The following risks are some to be aware of.

Firstly, the individual or business you lend to may default their loan. Promising a 25% return is great but if the borrower can’t pay you back it’s a disaster. Middlemen companies such as Zopa have a safeguard fund for these situations but this is far from a guarantee and past performance is not a predictor of future performance.

Next, have you considered the possibility of the middleman company going bust? As none of them are currently covered by the financial services compensation scheme (FSCS) I’m guessing any cash you keep with them isn’t safe if their company sinks. Some of them are now governed by the financial conduct authority (FCA) who in theory will ensure that any money that’s already been lent should continue to be repaid by the borrower even if the middleman disappears.

Other things to consider are the liquidity of a P2PL venture and diversifying across several sectors. If you invest your entire net worth into Saving Stream (i.e. property sector) then pray nothing bad happens to the property market!

In conclusion I think P2PL is a great idea but the above reasons are why I haven’t placed all my eggs into this basket. If you want to succeed in creating options for yourself later in life, you should strongly consider adding P2PL to your investing repertoire.

But as always, only after you’ve done thorough research and understand all the risks.

P.S. I learned everything I know about finance from this book, this book and that one, amongst many others. For a more extensive list, don’t hesitate to drop me a line at rory@ukdoctoronfire.com. If you prefer learning through listening use this link to earn a free audiobook of your choice by signing up to their 30-day free trial. Simply cancel with the click of a button if you decide later on that the service isn’t for you, no questions asked.

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