Bin your bank

Peer-to-peer lenders can offer better interest rates than banks because they take less of a cut. This is because they are typically online businesses, with fewer overheads than banks and building societies, which have high-street branches.

In the current low-interest-rate environment and amid the ongoing uncertainty facing risk assets, peer-to-peer lending appears to be an increasingly attractive option for investors, and it is estimated that peer-to-peer finance will account for more than £200m of loans to individuals and small businesses this year. Distrust of the banks could also be driving business to the peer-to-peer outfits, with 71 per cent of people believing that UK banks are corrupt, and almost three-quarters of wealthy individuals saying they would prefer a more personalised banking service, according to research by private bank Duncan Lawrie. Peer-to-peer website www.p2pmoney.co.uk estimates that p2p lenders have given out more than £337m in loans to date.

There are two main types of peer-to-peer lender: those that lend unsecured loans to private individuals, such as Zopa and RateSetter, and those that lend to businesses (often via secured loans), such as Funding Circle and Squirrl.com

Different lenders have different models and rates, which typically vary depending on how high-risk the borrower is. Charges are also reasonable for lenders, relative to some financial products. Zopa, for example, charges the lender a 1 per cent administration fee, while RateSetter takes 10 per cent of the interest you receive; the rates it advertises on its website (currently between 2.6 and 6 per cent) are quoted after this fee. Some companies, such as Squirrl, don't charge lenders. There are also low minimum lending levels, with some sites allowing people to invest as little as £10.

The pitfalls of p2p

But these enticing rates of income for investors do not come risk-free. The main and most obvious risk is that the borrowers default. Late payment could also be a problem, while in some cases the borrower might be able to pay off the loan early, meaning that you don't get all the interest you expected. As all the providers have slightly different models, you need to check the terms and conditions carefully before you invest.

With longer-term loans, you also have inflation and interest rate risk to contend with because, if these rise above the level of your interest, you could get left behind - although this is a risk with any fixed-income product. A deterioration in the economic climate and rising unemployment could lead to a rise in defaults. However, lenders argue that defaults have been very low to date. RateSetter, for example, has an historic default rate of just 0.29 per cent, while Zopa's annualised historic default rate is 0.5 per cent and Funding Circle's estimated annual bad debt rate is 2 per cent.

The peer-to-peer companies also say they take precautions to mitigate default. RateSetter has a provision fund to reimburse lenders in the case of defaults, so to date none of their lenders has lost out due to bad debt. The fund is also used to cover late payments. RateSetter makes very stringent checks on the credit quality of borrowers to keep defaults low; it typically rejects around 70 per cent of loan applications.

Zopa spreads the risk across several borrowers, so if you lend £2,000 or more, for example, your money is spread across at least 200 borrowers. It reviews every loan application to ensure all borrowers have a good credit history, so that people with county court judgements, high levels of unsecured debt or poor histories of credit repayment are not offered loans.

Peer-to-business lender Funding Circle vets the companies applying for loans to make sure they have a strong financial position, evidence they can make the monthly repayments, a healthy Experian credit report and no county court judgements against directors or the companies of £250 or above. To further minimise risk, it often asks borrowers for security, such as a personal guarantee from directors or major shareholders for loans under £100,000. For loans over £100,000, Funding Circle may take asset security over existing business assets or the asset the business is purchasing with the loan. But other companies have not been as careful and last year a peer-to-peer lender called Quakle collapsed due to a high level of defaults. It did not subject borrowers to rigorous credit checks.

Zopa, Funding Circle and RateSetter have set up the P2P Finance Association to try to maintain high minimum standards of protection for consumers and small business customers, and differentiate themselves from companies with lower standards. After Quakle's collapse, P2P said: "Quakle was not a member of the Peer-to-Peer Finance Association. We spoke to it about joining, but it said it was not able to adhere to our strict rules and operating principles. These were established to provide robust consumer protection in the current absence of appropriate regulation."

Diversification at a price

If your cash is in a regulated bank and the bank becomes insolvent, up to £85,000 of your savings will be repaid to you by the Financial Services Compensation Scheme (FSCS). If you have more than £85,000, you can spread it around different banking companies, as it is £85,000 per person, per company.

Peer-to-peer lending is not regulated, so you would not be compensated by the FSCS if one of these collapsed. But companies such as Zopa and RateSetter are currently regulated by the Office of Fair Trading under the Consumer Credit Act, and some ring-fence your loan money in accounts they do not have recourse to.

Another downside is that you cannot hold peer-to-peer loans in a self-invested personal pension (Sipp) or individual savings account (Isa), so your income will not be tax-efficient. For these reasons, advisers suggest that you do not commit more than around 5 per cent of your portfolio to peer-to-peer lending. Andrew Reeves, chartered financial planner at The Investment Coach, says you should only invest in peer-to-peer schemes if your risk profile is balanced or higher.

Stuart Law, chief executive of Assetz, which is about to launch a peer-to-business website, suggests you spread your investments between different peer sites and carefully monitor the performance and how they manage your money.

If you are lending to a business, you should be clear on what it does and what the risks are, and do some research on it. "If you are comfortable with a peer-to-peer lending company and its risk analysis, it can provide an alternative form of diversification for your portfolio," says Mr Reeves. "It can be a fairly reliable source of income. But it is for those who can afford to lose the money they lend."

The main p2p players

Bond funds can be held in an Isa or Sipp, mitigating income tax; and with a unit trust or Oeic you can normally get redemptions whenever you want. This may not be possible with a loan.

Corporate bond funds typically offer a yield of between 3 and 5 per cent, but if you have a high risk appetite you could consider a high-yield bond fund as these offer yields between about 5 and 9 per cent.

However, the level of risk you take with these bonds is more like the risks involved with equities as the default rate is higher than on investment-grade corporate bonds, so advisers such as Danny Cox, head of advice at Hargreaves Lansdown, tend to prefer strategic bond funds that have the freedom to invest in any area of the market their managers think best to make returns and avoid problems. "Don't be blinded by high headline rates of yield," he advises.

We include a number of these funds in our Top 100 Funds, such as Legal & General Dynamic Bond, Henderson Strategic Bond and M&G Optimal Income. These offer yields of up to around 7 per cent.

Charges on bond funds are higher, typically between 1 and 1.5 per cent a year. If you do not go via an adviser (which may involve a charge) you will incur a platform or broker charge as well, or if you go direct to the provider an initial charge. Minimum investment is higher than with peer-to-peer lending, usually £500 or £1,000.

A cheaper option with much lower minimum investment levels could be a high-yield bond exchange traded fund such as iShares Global High Yield Bond ETF, but this doesn't have an active manager to try to weed out risks.

Alternatives to peer-to-peer lending

Peer-to-peer loan companies' marketing pitch is that their rates beat what you can get on cash in the bank. However loans are a much riskier form of investment than cash, so it is not right to compare them. Cash rates may be low, but cash in the bank is virtually risk free. "Peer-to-peer lending is not interchangeable with a bank account," says Mr Reeves.

A better comparison would be risk assets. If you are able and willing to move up the risk scale from cash, bond funds invest in another form of debt. UK domiciled unit trusts and open-ended investment companies are usually regulated investments, so in the event of the fund provider going bankrupt the FSCS would pay up to £50,000 per person, per company in default. Such bond funds offer great diversification as they typically hold 100 bonds or more and are usually run by a very large team which will carry out in-depth research on getting the right bonds and managing risk.

Top 10 performing high-yield bond funds over three years