Is peer-to-peer lending the answer to your savings crisis?

Peer-to-peer lending can offer better returns than ISAs and other savings accounts, and this type of investing is to be made tax-free, says Julian Knight. But there are risks involved too

If your money is in a savings account then you are almost certainly getting poorer not richer. Yes, you read that right: savings are currently losing money.

This is because the rate on nearly all but a handful of savings accounts is below inflation, so the money you have on deposit will buy you fewer goods and services over time. That is what getting poorer means and it’s not good.

What’s more, the situation is getting worse as banks have been busily cutting savings rates over the past few months as they try to increase profit margins.

This, of course, doesn’t mean that you should turn your back on savings completely. They still have place in financial planning even if that place is as a last resort; an emergency float against sudden one-off expenses or job loss.

However, in this age of austerity, one per cent return or less doesn’t really cut it and that’s why so many people who would normally tuck their money into savings are looking at peer-to-peer lending.

How peer-to-peer investing works

Peer-to-peer is a very simple concept. You pay money into a peer-to-peer lending website, which is then made available to individuals and businesses to borrow. These websites work on an industrial scale, so millions of pounds worth of savers’ cash is lent out to thousands of borrowers.

Risk is relatively low as the amount of exposure an individual saver has to an individual borrower is very limited. Let’s say you as a saver pay in £1,000 and this cash is then lent out in parcels to 100 borrowers in equal £10 portions (as well as lots of other portions drawn from different individual savers).

Even if a few of the borrowers default – and the industry has a track record of a default rate of less than 0.5 per cent – it still means you are quids in, as the majority of borrowers pay back all that they have borrowed plus interest.

Peer-to-peer has been around for nearly a decade in the UK and was pioneered by the website Zopa but there are now several providers catering for loans to individuals and businesses such as RateSetter and funding circle.

Money going into peer-to-peer has grown steadily since then but more recently there has been a step change with the savings rate calamity leading to a sudden influx of cash into peer-to-peer.

How much money will I make?

On average, returns on peer-to-peer beats savings hands down. Currently, RateSetter says it is paying 3.6 per cent over a year and up to 6.2 per cent over five years, while Zopa returns are at 3.7 per cent for three years and 5.2 per cent for five years.

This is nearly double the rate paid by even the very best paying cash Individual Savings Account (ISA).

And the continuing reluctance of banks to lend to small and sometimes medium-sized business means that the peer-to-peer model is growing in the business lending sector too. The likes of Funding Circle, Rebuilding Society and Thin Cats all enable you to lend your money to small businesses, rather than individuals.

This is riskier than lending to individuals but rewards can touch double figures, which in a low interest rate world is not to be sniffed at.  

It is important to remember that, unlike a savings account, which is very safe regardless of who you deposit your cash with, in the world of peer-to-peer there can be marked differences in the risks attached to the investment from website to website.

But as a rule of thumb, lending to individuals with good credit ratings is generally less risky than lending to people with poorer credit histories and less risky still than lending to small business.

But the small business peer-to-peer websites will impose strict criteria on firms looking to borrow – such as having filled at least three years of accounts, and be making a profit in the last financial year so as to avoid losing investors cash.

After all, the last thing a peer-to-peer website wants is to gain a reputation as having a higher than normal default rate and thereby losing saver cash.

Tax-free returns coming

Unlike ISAs, at present returns on peer-to-peer are taxable at your marginal income tax rate. However, this is about to change. Peer-to-peer websites are to be allowed to offer their products tax free of returns.

In effect, peer-to-peer will soon enjoy the same tax advantages as an standard individual savings account. A final date for when this happens is not set in stone but the peer-to-peer industry has said that it expects a definitive answer from the government by the end of the year.

But even without the tax break, peer-to-peer is winning many admirers among people fed up with paltry savings rates. 

However, there are substantial health warnings.

Zopa, for instance, suggests that people new to peer-to-peer start small. Accounts can be opened with as little as £10. 

By starting small, savers can familiarise themselves with how the sites work and the different options available for where their hard-earned cash can be invested.

Whether it, for example, should only go to borrowers with a whiter than white credit rating or more risk should be taken (and potentially more reward gained) by allowing people with a poorer credit rating access to the money.

Peer-to-peer risks

Be aware, though, risks are greater than with a savings account and money invested through peer-to-peer is not protected by the financial services compensation scheme. The industry has been regulated since April by the Financial Conduct Authority, which should give some assurances. But it may not be as easy to withdraw cash from peer-to-peer than savings.

Many providers impose restrictions so once your money is in place you can’t take it out for a specified period such as a year or five years.

On the flip side, some providers do offer investors the option of selling their holdings to other investors, but fees are charged.

Peer-to-peer is certainly an attractive alternative to paltry savings but it comes with slightly greater risks and a little less liquidity. But you may think that those are prices worth paying next time you open your savings account statement. Remember, as we stand right now, savings are making you poorer, not richer.

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