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P2P lending 101 - What are the risks

Posted on 05 Feb 2015 by Chris Torney

If you have some spare cash to invest, the rate of return you get – or can expect to get – will depend on the amount of risk you are willing to take.

At the most conservative end of the risk spectrum you will find cash savings accounts offered either by banks and building societies or the government through the state-backed National Savings & Investments.

Here, at least the first £85,000 of whatever anyone deposits with a single institution is guaranteed by the government through the official Financial Services Compensation Scheme. So provided the UK remains solvent, your money (or certainly most of it) is safe.

The quid pro quo for this security is that returns are low – particularly given the low-interest-rate environment that has pervaded Britain since the start of the financial crisis.

If you shop around you might be able to get as much as 1.5% annual interest on an instant-access account and a little more if you are happy to tie your money up for a few years. This may be enough to offset the impact of inflation, but only just.

At the other end of the risk scale as far as most of us are concerned are equity-based investments – individual company shares or funds which hold a portfolio of shares. Some shares are listed on regulated stock exchanges, while shares in start-ups are typically unlisted and riskier investments.

Here there are no guarantees: if the firm whose shares you’ve bought goes out of business next week, you could lose everything you’ve invested. But the potential upside is much greater too. If the pharma company you’ve put money into suddenly reveals it’s found a cure for a specific disease, your returns could be stratospheric.

Investment funds reduce this risk by diversifying: they typically hold shares in a wide range of companies, sectors and even countries, so if some of their portfolio does badly it can be offset by gains elsewhere.

Nonetheless, over the long run returns on indexes of shares on regulated stock exchanges are expected to outperform savings accounts.

Zopa and peer-to-peer lending offers a middle way between these two extremes. Your capital is still at risk with P2P lending, as with any other form of investment that is not covered by the FSCS guarantee mentioned above. But by lending your money to a number of different borrowers, you can get better returns than on cash savings accounts with more risk but much less risk than investing in shares.

How Zopa reduces the risk

The risk involved in lending money, whether you’re a bank or a user of a P2P lending platform, is that some of the borrowers will miss repayments or default.

So how does a platform like Zopa minimise this risk?

The first step is by carrying out credit and identity checks and approving only the most creditworthy applicants. This means that only people who meet a strict borrowing criteria and affordability check are approved for a loan.

Next, platforms like Zopa use the diversification tactic mentioned above: each Zopa lender lends money in small chunks to many borrowers so if one borrower can’t pay back what they owe, their lender is still unlikely to lose their capital even though their overall rate of return may fall. Not all P2P platforms diversify funds across many borrowers like Zopa does, so be sure to check which ones do.

Finally, Zopa has a Safeguard Fund in place to protect lenders against defaults. If a borrower fails to make more than four monthly repayments the fund automatically repays the lender that borrower’s loan in full including interest owed.

Full details about the risks involved in lending can be found on our website.

Investing through Isas

The government has said it will allow P2P lending to be held in an Isa (individual savings account), which would make returns free of income tax. There has been a consultation on exactly how the Isa system should accommodate P2P lending and we expect clarification and guidance from the Treasury at the end of March.

Currently there are two types of Isas: cash, for bank and building society deposits, and stocks-and-shares Isas for equity investments.

For the reasons outlined above concerning risk, P2P lending doesn’t really fit into either category. It’s not the same as putting money in a savings account as Zopa is not a bank, nor does it carry the same level of risk as stock market investments.

That’s why we think the least confusing approach should be to create a new category of Isa purely for P2P Lending and hope the government creates a third Isa.

Category: Lending
Tags: safeguard

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