Peer-to-peer lending: Advantages and disadvantages for lenders
With the alternative finance market growing, peer-to-peer lending (P2P) has led the way with the biggest share of this market (University of Cambridge). As P2P platforms grow, they are beginning to become a mainstream asset class for potential new investors.
In this guide, we're going to take a look at the advantages and disadvantages of peer-to-peer lending, with the aim of helping you decide whether an investment in P2P lending is for you or not. Read on to find out more.
There are a number of advantages to P2P lending for lenders, including the potential to grow your money quicker than with a traditional savings account, as well as an opportunity to diversify your investment portfolio. Let's look at some of these advantages in more depth.
P2P offers an appealing risk and reward ratio, driven by sensible rates of return
Over the past few years, traditional savings accounts and cash ISAs have struggled to offer savers a higher rate of interest than inflation, meaning that savings lose their spending power over time. This has caused people to explore other avenues for boosting their portfolio, with peer-to-peer lending being an option that has created above-inflation rate returns.
And, while inflation — as well as wage growth and the cost of living — remain uncertain, P2P should still offer a better rate of return. For instance, here at Lending Works, our P2P lending service can see lenders earn up to 6.5% p.a. when they invest over 5 years and up to 5% p.a. over 3 years. If you're looking for an alternative way to boost your investment portfolio without taking significant risks, peer-to-peer lending might be just what you need.
P2P is a great option for diversifying your investment portfolio
One of the ways that investors can reduce the risk to their assets is by diversifying: spreading their money over a range of different investments. With a portfolio of investments, your funds are much less likely to be affected by economic turbulence.
The emergence of peer-to-peer lending has provided a new opportunity for investors looking to make low-risk investments, and another option for those looking to build up a diverse portfolio of assets. At Lending Works, we even use diversification to protect our lenders' money by spreading investments across loans, therefore lowering the level of risk should a borrower default.
P2P platforms are FCA regulated
Another advantage of peer-to-peer lending is that it’s regulated by the Financial Conduct Authority (FCA), providing a framework that must be followed to ensure a fair and transparent service for customers. The FCA is the body responsible for ensuring that the UK's financial sector follows the law, so their involvement offers some peace of mind if you're new to the P2P sector.
As part of the framework, there is a strong emphasis on P2P platforms providing a transparent service for their customers, as well as providing them with all the information they need to make an informed decision about their investment. This means that you should be able to access all the guidance you need before you decide to invest with a P2P platform.
At Lending Works, we provide a detailed overview of what our customers can expect from our service, as well as more in-depth information in our help centre. If you still need more advice, you can always contact us, and we'll be happy to answer any queries you have.
Some P2P platforms offer protection for your investment
While investing in peer-to-peer lending generally carries a modest level of risk, some P2P platforms will offer lenders a high level of security, often through a contingency fund. This means that if a number of loans are in arrears or defaulted on, the platform will be able to step in and cushion any potential loss for lenders with money tied up in those loans.
It's also worth remembering that P2P platforms have their own underwriting process for loan applicants. You can expect a good platform to carry out credit, affordability, identity, and fraud checks throughout the application process. With these precautions, your money is much more likely to go to a creditworthy borrower who will be able to pay it back on time.
When it comes to protecting your investment at Lending Works, we offer a belt and braces style approach through our Lending Works Shield. We have a sizeable contingency fund to cover arrears and defaults, so you can expect to receive the money you're due at the expected time. And, as we've mentioned, we always diversify your investment over all loans disbursed in the given annual cohort to guard against defaults.
You can withdraw your funds at any time
A great advantage of P2P lending is that you will have access to a flexible service that allows you to add and withdraw your funds easily, provided that there are other lenders available to replace you in the loans you wish to withdraw from. This differs from other types of investment that require a long-term commitment, such as property. While you will need to commit for a longer period to see the best returns, P2P lending can be an attractive option if you need that extra flexibility.
For instance, at Lending Works, you have the option to take out funds at any stage of the lending process. You can withdraw money in your wallet at any time without charge and you can even use our Auto-Income option so that your earnings are moved over to your bank each month. You can also withdraw money that's on offer for loan by cancelling the offer and then withdrawing it fee-free. We can even enable you to access funds that are already on loan with our Quick Withdraw service, which allows you to sell some or all of your loans to other lenders, though there could be a fee for doing so and there must be other lenders available to replace you in the loans you wish to withdraw from.
P2P lending has the potential to be tax-free with an Innovative Finance ISA
Should you be earning more interest on your savings than the remaining value of your personal savings allowance, peer-to-peer lending has the potential to be tax-free if you're in the position to open an Innovative Finance ISA (IFISA). These ISAs are operated by P2P platforms, so their lenders can maximise their earnings. They represent a great opportunity if you're looking to invest a significant amount into a P2P platform — be sure to read our guide to IFISAs for more detail.
However, it is worth bearing in mind that there are limitations on how many ISAs you can open and how much you can save and invest in a single tax year, which may affect whether you can access tax-free P2P lending. And, if you’re already earning interest below your tax allowance, opening an IFISA is probably an unnecessary step — check out our guide to tax on savings for more information on this.
The right P2P platform offers a great chance to make an ethical investment
One of the more overlooked advantages of P2P lending is the opportunity it offers to make an ethical investment. More people are looking to make ethically conscious decisions when investing their money, and because of their direct and transparent model, peer-to-peer lending has become a popular alternative to the murkier options offered by banks and building societies.
By choosing a P2P platform that offers a clear and fair service to both lenders and borrowers, as well as a thorough underwriting process, you can have peace of mind knowing your funds are being passed on to creditworthy people who can afford to pay back the loan. Here at Lending Works, we aim to be transparent at all times, providing all of our customers with the information they need to make sensible decisions with their money upfront and in an easily-understandable format.
Many of our borrowers use their loans to improve their lives. Some of our common loan purposes include helping people consolidate debt, finance a car, improve their home, or even pay for a wedding. If you're looking to invest your cash ethically, you can use our P2P platform to enrich the lives of others along the way. Our guide to investing ethically is well worth a read if you'd like to know more about the subject.
Although peer-to-peer lending has many strengths, there are some potential drawbacks you may wish to consider if you're thinking of investing your money. Let's investigate a few of these.
P2P lending is not covered by the Financial Services Compensation Scheme (FSCS)
The government's Financial Services Compensation Scheme (FSCS) covers losses up to £85,000 should a financial service provider go out of business. It's designed to be a safety net against potentially devastating loss and covers services like banks and building societies, credit unions, pension providers, and insurance providers. Unfortunately, peer-to-peer lending is not currently covered by the FSCS, so it's important that you're aware of this before you invest.
However, the best P2P platforms do offer a solid risk-management plan that will not only hugely reduce the chances of your money being lost, but will provide a back-up service to ensure you can still manage your assets should the worst happen. For instance, at Lending Works we have the Lending Works Shield that comprises safeguards like a contingency fund and a back-up service agreement. With the right management, putting your money into a P2P lending platform can be a relatively low-risk investment.
You can find out more about risk and how it is managed in our guide: Is peer-to-peer lending safe?
You need to lock up your funds for a period of time to get the best returns
Another drawback of peer-to-peer lending is that to really see the best returns you need to keep your funds invested for a period of time, usually more than a year. This means having to accept the fact your savings won't be available for a while if you want to maximise earnings.
While this can be off-putting for those that need flexibility in their finances, it's worth remembering that most forms of investment require a significant commitment to really see the full benefit. And, the best P2P platforms offer a withdraw option that will allow you to sell your loans to other investors if you need to take out money that has already been lent out.
There may be a wait before a loan offer is made with your funds
Once you've invested your money with a peer-to-peer lending service, there may be a wait until you're matched with borrowers who are seeking a loan with the same terms. While it's not usually a long wait, each day without a match is one where you're not earning interest. On the other hand, you could be matched with someone immediately and begin accumulating interest from day one — it all depends on the supply and demand at the time you choose to invest.
Here at Lending Works, we provide you with as much information as possible when you're at the loan matching stage. We provide detail of how much money is queued ahead of you, as well as a rough estimate on how much time you may need to wait. We also use a 'Fair Algorithm' to work out which money should be matched where in the fairest way possible, and reinvested cash always gets priority over new money. To ensure your reinvestments go back to earning you interest as quickly as possible, we offer an automatic re-lending service that you can choose to use.
It is important that we highlight that with any peer-to-peer lending platform, your capital is at risk.