Person to person loans
If you have ever borrowed or lent money to a friend, you will have an idea of what person to person lending is. It is an idea that ordinary people who have extra money they want to invest, can do so by giving loans to other people just as a bank would.
What separates peer to peer loans from the traditional way of lending to a friend is that in this case the lender and borrower are strangers to one another, it is also done for profit; the lender expects to earn interest on their investment whereas you wouldn't charge your friend interest on a loan.
How they work
As a borrower you sign up with a peer-to-peer company (a middleman who bring lenders and borrowers together), in the UK Zopa is the biggest having lent over £940 million since 2005, others include; RateSetter and LendingWorks.
After signing up for an account the application process is similar to bank loans; you provide your details and a credit check will be carried out. If you meet all requirements and are considered credit worthy, you get a quote based on your credit score; the better your credit score the less interest you're likely to pay.
If you’re happy with the quote, you accept and money will be pooled from several lenders and deposited into your bank account. In most cases repayments will be taken directly from your current account, you can also manage your account online.
In order to lend, you needs to sign up a lender account which will be connected to your current account. A lender doesn't need to have a lot of money to get started, On Zopa for example, you can start with as little as £10.
Once you've got the money into the account, you can decide the level of risk you want to lend at; the lending website will score each loan applicant, they will also explain the risk levels to you.
If you decide to lend only to those with high credit scores, it is less risky but you will earn less interest, on the other hand, if you lend to low credit score applicants you stand to earn more interest but there's also more risk of bad debt. Most person to person lending websites require you to investment for a period of 1, 3, or 5 years, longer investment periods yield more interest.
Lending to small Businesses
Apart from lending to other people, you can lend also to small businesses across the UK. It is similar to lending individuals except that you can review the business before deciding whether or not to invest; the business owners will present themselves outlining what they do, why they need the money and how they’ll be able to pay it back. The lending website carries out the necessary checks such as the legitimacy of the business.
Funding Circle is the most established in this category having lent over £700million and with a £60 million investment from the UK Government. Their loans work on an auction basis whereby investors can out bid one another for the most attractive investments; the more investors a business attracts the less interest they pay.
As a lender you can spread your investment over many businesses to minimise risk, you may also sell your share in a loan if you need to get out an investment. Statistically, investors in Funding Circle get far higher returns than compared to keeping money in a savings account, as you can see in these charts.
Are they Safe?
Peer-to-peer lending websites are now regulated by the Financial Conduct Authority; they must follow consumer protection rules as laid out by the FCA. This however doesn’t make them full proof; like any investment outside of government guaranteed savings accounts, there’s a chance something could go wrong and cost you your investment.
The lending websites provide a lot of tips on how to minimise the risk of losing your money, it’s advisable to read through before making an investment.
Peer-to-peer lending also has a charitable aspect to it; you can lend money to entrepreneurs in developing countries, they use the money to start or expand a business and once the business starts to make money they repay the loan.
One of the pioneers in this category is Kiva, where entrepreneurs from around the world create profiles, tell their stories and outline what they plan to do with the money, you then choose whom to help. After the loan has been issued, as well as making repayments, the entrepreneur will regularly update you on the progress of their business.
Kiva is a charity and you will not earn any interest on the loans you make, however, the partners they work with do charge interest and other fees.
Why they’re a good idea
For the borrower, peer to peer loans can be cheaper than bank loans; this is because the people who lend set their own interest rates, if there is enough competition some lenders will lower their interest rate.
Online account management
Both lender and borrower can manage their accounts online, some lending websites will even allow early repayments without imposing an early settlement fee.
Social good that makes money
Traditionally, only financial institutions have been able to loan money and charge an interest. With peer to peer loans, an ordinary person can play that role and not only help out small businesses, but also make themselves some money in the process; the interest rate you earn is normally higher than what you get on money in a savings account.
Not available to people with bad credit
Applicants who have bad credit are unlikely to get approved as lending websites have so far opted to minimise the risk to their lenders, this may change in the future as confidence grows in these new platforms.
You can experience bad debt just like the banks
As you would be lending your money to other people, you are exposed to defaults or troubled repayments just as a bank would be exposed to those risks. The lending website would have procedures in place to try and protect you from bad debt, however, it is still possible to lose your money.