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Knockout Rates

Peer-to-peer returns easily beat those on offer from the banks, but how does the market’s newest contender shape up in terms of risk?
July 18, 2014

With prevailing low interest rates, investors have been forced to look to higher-risk sources of income such as equity income and property, but in recent years another option has emerged: peer-to-peer lending. Peer-to-peer lenders are like alternative banks in that they bring together potential lenders and borrowers via their websites, offering both parties terms that beat bank rates. Peer-to-peer lenders can offer better interest rates than banks because they take less of a cut. They are able to do this as they are typically online businesses with fewer overheads than banks and building societies, which have high street branches.

Peer-to-peer lending is growing, too, with over £1bn of funds lent via this means in the UK.

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. Some companies lend to both individuals and businesses, examples including Mayfair Bridging and LendInvest.

Investors lending money via peer-to-peer websites can get a return on their cash of anything between 3 and 10 per cent, and sometimes more.

Charges are typically low relative to some other types of debt investments such as bond funds. Zopa, for example, charges the lender a 1 per cent administration fee, while Funding Circle charges a 1 per cent annual fee on the amount of money you have lent, collected when you receive a payment. This means less of your returns are eaten into.

There are also low minimum lending levels, with some sites allowing you to invest as little as £10. In a corporate bond fund, by contrast, you typically need to invest a minimum of £500 or £1,000.

Peer-to-peer loans could help to diversify your portfolio as this kind of debt is probably different to anything you already have, such as corporate bond funds or gilts – UK government bonds. It could account for a small part of your investments to add diversification and potential extra return to mainstream investments, such as equities, bonds, property and cash.

Since April, peer-to-peer lending has been regulated by the Financial Conduct Authority (FCA), meaning more rights and greater protection for lenders. The regulator’s rules include that peer-to-peer lenders must present information clearly, be honest about risks and have plans ready in case things go wrong. If they don’t do this they could face fines.

Risks

The main and most obvious risk with peer-to-peer lending – as with all forms of debt – is that the borrowers default, and you could lose your capital. Lenders argue that defaults have been very low to date: for example, Funding Circle’s current bad debt rate is 1.4 per cent.

However, peer-to-peer lending is a relatively new form of finance, less than 10 years old. Most of the lenders have been set up after the financial crisis, meaning they haven’t been through many testing times, with the exception of Zopa. A deterioration in the economic climate and rising unemployment could lead to an increase in defaults.

Zopa, for example, had a default rate in 2008 of 5.91 per cent but this fell back to 2.32 per cent in 2009 and in 2013 it was 0.23 per cent.

Peer-to-peer companies take precautions to mitigate default. These include having a provision fund to reimburse lenders in the case of defaults, and in some cases cover late payments. Ratesetter, for example, says that no lender has lost money because of its provision fund which is the largest among UK peer-to-peer lenders at around £5m.

Peer-to-peer lenders make checks on the credit quality of potential borrowers. This means that ones with, for example, county court judgements, high levels of unsecured debt, or poor credit histories may be refused a loan.

Peer-to-peer lenders may spread the risk across several borrowers, in some cases 200 or more.

In the case of a company loan, the peer-to-peer lender may ask for a personal guarantee from directors or take security over assets.

Credit checks are important because a high level of defaults can lead a peer-to-peer lender to collapse, as well as to individual lenders not getting their money back. A peer-to-peer lender called Quakle did not subject borrowers to rigorous credit checks and collapsed in 2011.

A major difference with bank accounts is that peer-to-peer lending is not covered by the Financial Services Compensation Scheme (FSCS) in the event of one of these companies collapsing. If your cash is in a regulated bank and the bank becomes insolvent, up to £85,000 of your savings per company will be repaid to you via this scheme.

However, some peer-to-peer lenders ring-fence your loan money in accounts they do not have recourse to, providing some protection.

Other risks include the borrower paying their loan back late, so even if you do recover your capital you have to wait longer than expected. And in some cases, the borrower might be able to pay off the loan early, meaning you don’t get all the interest you thought you would.

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 will get left behind – although this is a risk with any fixed-income product.

And you may not be able to access your cash before the term is due: peer-to-peer loans are not instant access like a savings account. Some peer-to-peer lending sites allow you to withdraw funds early if you wish, but there may be a fee.

Peer-to-peer lending frequently gets described as an alternative to bank loans, but because of these risks you should definitely not consider it as an alternative to cash, which is virtually risk-free. Rather, peer-to-peer lending should be considered as a high return, but high risk alternative investment in your portfolio.

For these reasons, advisers suggest you only invest in peer-to-peer lending if your risk profile is medium or higher, and that you do not commit more than around 5 per cent of your portfolio to it – money you can afford to lose.

Picking a platform

When choosing a peer-to-peer lender, as with your other investments, it is important to research the company and product on offer.

Make sure the company you choose is FCA regulated. You can check which companies are regulated via the FCA website or call its consumer helpline. If a peer-to-peer company does not register with the FCA, it could be shut down.

A number of peer-to-peer schemes hold Consumer Credit Licences from the Office of Fair Trading, and use the same processes and fraud prevention systems as banks. Check if they use these and what protection is in place, such as the size of any provision fund to cover defaults.

Also, check how the peer-to-peer lender vets potential loan recipients and what its level of defaults is. You should be able to check peer-to-peer companies’ bad debt rates on their websites.

And see if the advertised rates of interest include fees and charges, and if not, what your actual rate of return is likely to be.

If you are lending to a business rather than an individual, you should be clear on what it does and what the risks are, and do some research on it.

If you have other investments, consider how the type of loans being offered fit with the rest of your portfolio. You may, for example, want to avoid investing in mortgages if you already have a buy-to-let property.

A good way to mitigate risk is to diversify your investments, so you could make loans with a number of different peer-to-peer companies, although some will spread your risk across many borrowers.

All the providers have different models, and as the industry has grown peer-to-peer lenders offer loans to different types of borrowers for a variety of different purposes. You need to check their terms and conditions carefully before you invest, and what the nature of the borrower and loan is.

Peer-to-peer associations

Eight peer-to-peer lenders are members of the P2P Finance Association, which tries to maintain high minimum standards of protection for consumers and small business customers, and differentiate its members from companies with lower standards.

These are Zopa, RateSetter, Funding Circle, ThinCats, LendInvest, Madiston LendLoanInvest, Wellesley & Co and MarketInvoice.

Zopa, Funding Circle and RateSetter are the founder members and among the longest established of the peer-to-peer lenders.

The P2P Finance Association works to promote high standards of business conduct and consumer protection across the sector, and requires members to abide by its rules and operating principles.

When applying to join the P2P Finance Association, a company must show how it complies with the P2P Finance Association’s operating principles. The operating principles set out the key requirements for the transparent, fair, robust and orderly operation of peer-to-peer finance platforms.

Some peer-to-peer lenders such as QuidCycle and LendInvest are members of The UK Crowdfunding Association, which was formed in 2012 by 14 businesses. It aims to:

• promote crowdfunding as a valuable and viable way for UK businesses, projects or ventures to raise funds;
• represent crowdfunding businesses in the UK to the public, press and policymakers; and
• publish a code of practice that is adopted by UK crowdfunding businesses.

But membership of one of these organisations is not a guarantee things won’t go wrong, so you should still do thorough research on a company and the loans you are going to make before you invest.

Isas

The government is going to make it possible to hold peer-to-peer loans in individual savings accounts (Isas), making peer-to-peer loans even more attractive. The interest you earn from peer-to-peer loans incurs income tax, but this would not be the case if held inside an Isa. This is expected to come into effect from April next year.

The Treasury is about to launch a consultation on how peer-to-peer loans can be held in Isas and is looking at different options. These include allowing stocks and shares Isas to hold peer-to-peer loans alongside other investments.

Another option would be stocks and shares Isas that only invest in peer-to-peer lending. However, this would severely limit choice as you can only open one stocks and shares Isa a year, and so would have to put your savings only in peer to peer and cash.

Or there could be a third Isa category based purely on peer-to-peer which would allow investors to hold these alongside Isas invested in cash, and stocks and shares.

It has already been agreed that the peer-to-peer platforms will be able to offer their own product direct and act as Isa managers, although it is hoped that other Isa managers will offer peer-to-peer loans. The main fund platforms have not yet said what their plans are, in part because they are waiting to see the outcome of the Treasury consultation.

Sipps

Peer-to-peer loans can already be held in pensions such as self-invested personal pensions (Sipps), which also confer various tax benefits. For example, investments in a pension can grow free of capital gains and income tax. But at present very few Sipp operators accept peer-to-peer loans in their wrappers: the ones that do tend to be smaller operators offering full service Sipps for investors with large amounts of assets.

Brian Bennis, founder of information service SIPPclub, says that Sipp providers are reluctant to include peer-to-peer loans because a loan from your Sipp to a business that is connected to you, a family member, or business associate is treated by HM Revenue & Customs (HMRC) as an unauthorised payment and is subject to large tax charges – up to 55 per cent – against you personally, as well as tax charges against your pension scheme.

“In general terms, the business is connected for these purposes if you, together with connected parties including your Sipp, have control over the business,” he says. “With many of the peer-to-peer networks allowing auto-bidding, it’s impossible to check whether this rule is being broken. As a result, most Sipp operators aren’t willing to allow their clients to run the risk of incurring large tax charges.”

A connected party includes your spouse, registered civil partner, relative, or relative of the spouse or registered civil partner.

However, Rhydian Lewis, chief executive officer of RateSetter, says that peer-to-peer platforms will find ways to control this – for example, by asking lenders to give a list of their connected parties so the platform can ensure they are not matched with them. Ratesetter already has a clause written into its terms and conditions which says lenders cannot lend to a connected party, in preparation for its loans being included in Sipps.

Scheme administrator Whitehall Group, meanwhile, asks clients for an indemnity that the funds lent will not be diverted back to themselves.

Sipps also can’t hold residential property. However, Mr Bennis points out that you can lend money where the loan is secured against residential property, providing that in the event of a default you use a security trustee to call in the charge, liquidate the property and turn it into cash. By doing it this way the Sipp only ever receives cash back, rather than the residential property.

Another problem is that the FCA wants to increase the amount of cash Sipp operators hold in their businesses, to protect Sipp holders. But the FCA has postponed its decision on this to the end of the year, so the situation for Sipp providers is uncertain. “As a result, almost no Sipp operator wants to take on new non stock market investments at the present time, such as peer-to-peer lending, as it could become very costly to hold them from next year,” adds Mr Bennis.

If you are interested in investing your Sipp in peer-to-peer loans you should ask your Sipp provider what its policy is. If you do not already have a Sipp or are switching provider, before you sign up you should ensure it will allow you to invest in what you want, particularly if you plan to make a wide range of investments including peer-to-peer loans. And check all the costs involved: these can be very high with full service Sipps.

Ian Thomas, co-founder and director of LendInvest, adds that the due diligence required for holding peer-to-peer loans in Sipps could incur high costs, so this asset is not viable for smaller Sipps.

Around 6 per cent of the funds on peer-to-peer lender ThinCats’ platform are from 30 different personal pension funds, and it has done this via companies such as wealth manager Torquil Clarke.

Whitehall Group allows investors to hold peer-to-peer loans in small self-administered schemes (SSAS) and has taken in loans from providers such as LendInvest, Platform Black and Assetz Capital.

Charles Stanley offers a full-service Sipp offering and says it would permit a loan to an unconnected company.

Peer-to-peer lender Ratesetter is to start a project to try and get peer-to-peer loans generally accepted as Sipp investments, and this will include working with the Treasury over the coming months. The company hopes it can start offering its loans via Sipps from next year and is looking to work with a Sipp provider.