Peer to peer lending and how does it work?

Find out how peer to peer lending has changed the way businesses find finance and lenders grow their savings by cutting out the banks

Peer to peer lending (P2P lending) is a relatively new form of borrowing. It has only been around since 2005, and since then has grown in popularity as an alternative source of finance for businesses and individuals.

P2P lending sites connect people looking to borrow money with people who have capital which they want to grow. By connecting borrowers and lenders directly, both parties can often get a better deal, cutting out all the costs usually taken by the middleman, which tends to be a commercial lending bank.

Find out more about how peer to peer lending works in the following sections:

  • What is peer to peer lending?
  • Types of P2P lending
  • Advantages & disadvantages of P2P lending (borrowers)
  • Advantages & disadvantages of P2P lending (lenders/investors)
  • Final thoughts &FAQs

What is peer to peer lending?

Peer to peer lending is a model of debt-based crowdfunding which takes place through online platforms. These platforms match lenders (often referred to as investors in a P2P finance context) looking to grow their wealth via offering loans with individuals or companies looking to borrow funds. This model cuts out the bank, or the intermediary, with the intention of reducing the cost for both parties.

Lenders can often get much higher rates than they would from a savings account, while borrowers pay less interest than they would with a conventional loan.

P2P lending can be used for all types of loans. P2P loans tend to be personal loans or small business loans in the majority of cases, however there are some less common types including:

  • Home improvement loans
  • Auto loans
  • Medical loans
  • Student loans.

When P2P lending first came about, it was a lending system designed to offer access to credit for people and businesses rejected by conventional finance institutions. However, as P2P lending platforms have grown in popularity P2P loans are more and more being taken out by businesses and individuals just looking more favourable rates as opposed to traditional loan finance.

How does the P2P lending process work?

Many peer to peer loans are classed as unsecured personal loans, which means there’s no security or collateral needed to take out the loan (in many cases even loans for business purposes).

As such, it’s one of the more accessible forms of funding, and one of the lower-risk finance options for borrowers. The process of P2P lending is different for lenders and borrowers, each group/process is detailed further below.

From a borrower perspective

The P2P finance process from a borrower perspective largely follows the below steps:

  • Complete and submit an application form, usually done online. As part of this process, the lending company typically carries out a credit check.
  • Based on the information you provide, the lending platform assigns you a risk category or grade. This rating determines the interest rates and terms that you will be offered. If you’re happy with an offer, you can choose to proceed.
  • Investors then review your loan request, including how you plan to spend the money and why you don’t pose a high risk. On some sites, lenders may bid to try and win your business.
  • If an investor offers you a loan, you then have the option to review and accept it.
  • Once you’ve accepted the loan, the funds tend to appear in your account within a few hours or days.
  • You then make monthly payments to repay your loan. Generally, P2P lenders report accounts in the same way as traditional lenders, meaning that late repayment could harm your credit score. Some platforms may also charge fees for late payment, which are to watch out for.

From a lender perspective

Lenders (Investors) are people looking to grow their wealth by lending with the aim of seeing a return on their money. The process from a lending perspective typically follows the same as the below:

  • First of all, an investor opens an account with the relevant peer to peer lending website and deposits a sum of money that they want to loan out.
  • The lending party can set interest rates. On some sites, lenders will compete with one another to offer the lowest rate. On other sites, the peer to peer lending company will set a fixed rate based on the borrower’s credit rating and history. Lenders must decide how much they wish to lend and for how long. Typical loan terms are between one and five years.
  • Loan applicants post a financial profile on the same sites, detailing the amount they wish to borrow. Each loan applicant is assigned a risk category, determining the interest rate they will have to pay to borrow funds.
  • Loan providers can view the profiles and choose the applicants they want to offer a loan to, or set automated parameters that enable the site to do it for you.
  • The lending companies, or the P2P lending platforms, make money typically by collecting a one-time fee on loans from borrowers and, in some cases, charging a fee to investors to use the service.

Types of peer to peer lending

Broadly, you can group peer to peer lending into three categories:

  • lending to consumers
  • lending to businesses
  • lending against property.

Some P2P lending platforms are dedicated to just one of the above types of peer to peer lending, while others offer all three.

Consumer peer to peer lending

The most traditional form of peer to peer lending is consumer lending, which is how P2P started in the first place. It involves lending money to an individual, for whatever reason they need it.

When Zopa one of the first P2P lending platforms started, borrowers could state why they needed the money, and investors could choose the projects they wanted to back. Individuals might wish to secure cash to cover a gap in employment, to renovate their house or to start a business.

Nowadays, platforms tend to hide the reasons that individuals are seeking funding, but it works the same way. These type of personal loans are often unsecured, which makes it a bigger risk for the lender, as there’s little chance of recovering the money if the borrower defaults – however this typically allows investors to set higher interest rates to offset potential risk (this requires an investor to have made multiple loans though).

Business peer to peer lending

P2P business lending is becoming more and more popular as a source of finance for companies looking to fund growth, purchase materials, assets or stock or to bridge cash flow issues. Business lending tends to be secured against property, via other business assets or by a personal guarantee from the directors.

Property peer to peer lending

Lending against property is less common for P2P and typically used for short-term development projects, such as extensions or refurbishment. Property lending is also risky, as the project could always go wrong.

For the investor however, it carries fewer risks than unsecured P2P lending, as the loan is usually made on condition that the property can be sold to recover the monies owed in a worst-case scenario.

Advantages & disadvantages of P2P lending (borrower)

Peer to peer lending has shaken up the way that individuals and businesses can access finance. Removing the middle party has multiple benefits but comes with its disadvantages too.

Advantages for borrowers

  • P2P offers a useful alternative for those who have been rejected by the bank for a traditional bank loan, or who have been unsuccessful in finding funding through more conventional routes.
  • It’s a fast, efficient way for borrowers to get hold of the money they need, with the entire process being online. Successful loan applicants have been known to receive funds the same day, or in under 48 hours.
  • Borrowers benefit from fixed monthly payments and lower interest rates compared to banks.
  • Most loans are unsecured, meaning you don’t need to put up collateral or security.
  • There’s more flexibility in how you use the loan than through more conventional forms of finance.
  • Repayment is automatic.
  • There’s usually no penalty for repaying the funds early.
  • Borrowers can check their rates without their credit score being affected.

Disadvantages for borrowers

  • If you have poor credit, you may only be able to access the high-interest rates of up to 36%. Those with especially poor credit, usually below 630, may be ineligible for a loan on most P2P platforms.
  • There’s usually a cap to the amount you can borrow, typically around £30K.
  • Some sites have high fees, such as origination fees of up to 6%, early termination fees and late payment fees.
  • Missing your loan repayments will damage your credit score.
  • Banks usually reject borrowers for legitimate reasons. If a bank refuses you a loan because they think you can’t afford it, it may be risky to pursue a loan elsewhere.

Advantages & disadvantages of P2P lending (Lender/investor)

Peer to peer lending is an innovative way for individuals and businesses to secure the funds they need. If you’re looking to lend money, it can be a great way to grow your savings. However, there are significant advantages and disadvantages to consider for those looking to lend money through a P2P site.

Advantages for lenders

  • While P2P lending is not a form of saving in the traditional sense, the interest lenders earn from P2P are covered by the ‘personal savings allowance’ (PSA). This initiative brought in by the government in 2016 means that every basic-rate taxpayer (20% in 2020) can earn £1,000 in interest without paying tax on it. Beyond this limit, any interest you make on your peer to peer lending will be subject to tax.
  • It’s relatively liquid, meaning your funds are relatively easily accessible. If you invested the same funds in property, it could take months or even years to sell the property and get your money back. Of course, it’s not as liquid as keeping your money in a bank where you can withdraw it at any time, but the balance of liquidity and high returns makes it a favourable option for many savers.
  • P2P lending is a way for investors to diversify their investment portfolio by investing outside of stocks and bonds.
  • Many investors feel that it’s a more ethical way to invest funds by helping others access seed money for business ventures, or much-needed personal loans when banks have denied them funds.
  • Interest rates have been at a record low on savings accounts in the last few years. This low-interest-rate environment has led to a spike in peer to peer lending, as savers look for better returns on their savings. Peer to peer lending is an effective way for people to save their money with a far higher interest rate as, without the overheads from a middle person such as a bank, peer to peer investors can earn higher interest rates.
  • Peer to peer lending is arguably getting safer, as platforms carry out stricter credit checks. Investors also have the option to split their funds into smaller amounts lent out to multiple borrowers to reduce the risk of losing everything to one defaulting borrower.
  • Many sites have also introduced their own contingency schemes which assumes the risk of a defaulting borrower by guaranteeing to return an investor’s full savings if a borrower doesn’t pay up. Sites create this fund by charging a credit rate fee to each borrower between 0.5% to 3% of the loan, which contributes to the provision fund. These schemes encourage investors to use peer to peer lending by reducing their risk of losing their funds.

Disadvantages for lenders

  • Many lenders view peer to peer lending as a form of savings. This perception can be dangerous, as peer to peer lending does not come with a safety guarantee. It should be viewed and treated as an investment, with the necessary caution, as there is always the risk that you could lose all of your money if your borrower can’t pay. As there’s no intermediary party, you are exposed to much higher risk if your borrower defaults.
  • Savers are attracted by the high-interest rates, and many get persuaded to lend to higher-risk borrowers owing to the higher rate of return. The higher the borrower’s risk of defaulting, the higher your risk of losing your money, too.
  • Another risk to consider is whether your borrower repays your funds either early or late, which can damage your profits. If a borrower repays your loan early, you can lend the money out again through the website to a different borrower, but there is always the risk that you aren’t able to lend out at the same interest rate.
  • It can take time for the company to lend out your funds, and you won’t accumulate any interest in this period. This is something to bear in mind for significant investments, when it may take days to lend it all out.
  • There may come a time where you need the savings that you’ve invested in a peer to peer lending platform, particularly as one- to five-year loans are the standard. If you withdraw your funds early, some schemes charge a significant early-withdrawal fee. On some platforms, you may not be able to remove your money at all during the loan term. You may be able to sell the loan on to release your capital, but you will also incur a fee for this, and it may take more time than you can afford to wait.
  • Another thing to watch out for is that the rate lenders quote is not always guaranteed. Peer to peer lending companies will quote expected returns for investors, perhaps referred to as projected or target returns, but the actual rate you get could be less. A borrower might repay your loan early, or not at all, and if there’s no provision fund to cover the non-payment, then you could lose some of your investment.
  • There’s less liquidity than stocks or bonds owing to the extended loan terms, usually between one and five years.
  • Not all investors are eligible on all sites, as some restrict access to accredited investors only.
  • Lastly, peer to peer lending is still a relatively new phenomenon, only coming onto the scene in 2005. In May 2019, Lendy, a mid-sized peer to peer lending platform, collapsed, costing 9,000 investors up to £90 million. Lendy collapsed despite regulation by the FCA, demonstrating the unpredictability of the industry and the risk to investors.

Final thoughts & FAQs

Often hailed as one of the most innovative forms of investing and borrowing to come out of the last twenty years, P2P lending has seen a steep rise in popularity in the last decade that shows no signs of slowing down. By circumventing the conventional loan requirements and traditional funding routes, this form of finance offers competitive rates for lenders and borrowers alike.

As with any form of investment, P2P lending comes with significant risks. It’s never a guaranteed form of savings, and you never know when your P2P lender could go bust. That said, the market offers impressive growth rates and is a fantastic way for start ups to source their initial seed funding. For individuals, it’s also a more accessible way of getting credit, bypassing traditional admin-heavy routes. It is therefore worth considering next time you’re looking for quick access to a loan or an easy way to grow your funds.

How can lenders maximise P2P lending returns?

While you’re looking for a peer to peer funding platform to use, there are plenty of things to consider. Bear in mind the following when making your decision:

  • Focus on the platform, rather than the loan. P2P lending is one of the less time-consuming investment options. If you’re looking for good returns for minimum effort, opt for platforms that take care of your investments behind the scenes.
  • Diversify your investment. Just as putting all your eggs in one basket leaves you vulnerable to a defaulting borrower, the same goes for the number of platforms in which you invest. If you split your savings across several platforms, you reduce your risk if one of the platforms goes bust. That said, it can be hard to keep track of your funds when they’re spread across too many platforms, so investors recommend sticking to a maximum of five.
  • Look for an easy exit. Some platforms make it easy for lenders to withdraw their money, taking care of the rest. They’ll reallocate your loans to other lenders behind the scenes, meaning you get your money back quickly without any hassle.

How is P2P interest taxed?

For tax purposes, HMRC views most money earned through peer to peer lending as income, which is taxable. For most lenders, they won’t pay any tax due to the personal savings allowance, which allows basic rate (20% in 2020) taxpayers to earn up to £1,000 of tax-free interest.

Higher rate taxpayers (40% in 2020) have access to the same scheme but have a lower tax-free limit of £500. Any interest earned above these thresholds is liable to tax, which you must pay at your highest marginal rate of tax. Additional rate taxpayers are not eligible for a personal savings allowance, so anybody who earns more than £150,000 per year must pay tax on all their savings.

As with any form of investment, P2P lending comes with significant risks. It’s never a guaranteed form of savings, and you never know when your P2P lender could go bust. That said, the market offers impressive growth rates and is a fantastic way for start ups to source their initial seed funding. For individuals, it’s also a more accessible way of getting credit, bypassing traditional admin-heavy routes. It is therefore worth considering next time you’re looking for quick access to a loan or an easy way to grow your funds.

How can lenders maximise P2P lending returns?

While you’re looking for a peer to peer funding platform to use, there are plenty of things to consider. Bear in mind the following when making your decision:

  • Focus on the platform, rather than the loan. P2P lending is one of the less time-consuming investment options. If you’re looking for good returns for minimum effort, opt for platforms that take care of your investments behind the scenes.
  • Diversify your investment. Just as putting all your eggs in one basket leaves you vulnerable to a defaulting borrower, the same goes for the number of platforms in which you invest. If you split your savings across several platforms, you reduce your risk if one of the platforms goes bust. That said, it can be hard to keep track of your funds when they’re spread across too many platforms, so investors recommend sticking to a maximum of five.
  • Look for an easy exit. Some platforms make it easy for lenders to withdraw their money, taking care of the rest. They’ll reallocate your loans to other lenders behind the scenes, meaning you get your money back quickly without any hassle.

How is P2P interest taxed?

For tax purposes, HMRC views most money earned through peer to peer lending as income, which is taxable. For most lenders, they won’t pay any tax due to the personal savings allowance, which allows basic rate (20% in 2020) taxpayers to earn up to £1,000 of tax-free interest.

Higher rate taxpayers (40% in 2020) have access to the same scheme but have a lower tax-free limit of £500. Any interest earned above these thresholds is liable to tax, which you must pay at your highest marginal rate of tax. Additional rate taxpayers are not eligible for a personal savings allowance, so anybody who earns more than £150,000 per year must pay tax on all their savings.

That said, many P2P websites have contingency funds or provision funds, which can pay out if a borrower defaults on their loan. For this reason, it’s essential only to use P2P websites which are regulated by the Financial Conduct Authority. Companies controlled in this way must keep lenders’ money in separate accounts to their own, which reduces the risk for the lender. These accounts are usually ringfenced and held with a different bank, which will be protected under the FSCS.

By Robert Lewis