Peer to peer lending – can these newcomers cut out the banks?

What is peer to peer lending?

Peer to peer lending – as with many things financial – is one of those things which can sound an awful lot more complicated and risky than it actually is.

So, over the next few minutes, we’re going to break it down for you by taking peer to peer (p2p) lending back to basics and explaining exactly how it works.

To coin a phrase, Peer to peer lending does “exactly what it says on the tin”. It offers you a way to borrow money to help you cover those unexpected bills, home improvement projects and the various other curve balls that life likes to throw at us now and again. However, P2P lending has one major difference to the more traditional borrowing schemes available on the financial market.

Rather than having to skulk on down to the bank and pitch your idea or need to a condescending and bank manager who’s never had to borrow a penny in his life, P2P lending brings the community together by connecting borrowers with savers, and allowing them to deal directly with each other. Being a part of a peer to peer lending community allows both savers and borrowers to benefit by cutting out those fat cat banker middle men, and getting a better deal for their pound. Much of this should now be sounding pretty familiar to any of you who have managed to catch channel 4’s “Bank Of Dave” series recently.

Peer to peer lending is a surprisingly simple and refreshingly easy way to borrow money when you need a bit of extra cash. But peer to peer lending is also more than that.

We all know that finances can be a bit turbulent; especially in these “touch and go” economic times of slim economic growth and narrowly avoided triple tip recessions. Just as there will be times when some unexpected bills crop up to cause you the occasional payday headache, there will also be some months where you inadvertently find yourself with some spare cash. Again, peer to peer lending comes to the rescue.

P2P lending can be a great way to put your spare cash to work, and start earning a nice residual income. The money you can earn from lending money out to your peers in this way is often far greater than your typical saving rates, even compared to high interest schemes such as tax free ISAs and the like.

So, right about now, this is all sounding pretty good, yeah? Well, a word of caution to those of you who are thinking about getting involved with a scheme or website like this…

As great as the idea is in principle, it is certainly not without risk. And peer to peer lending sites themselves have had an equally turbulent time in the press over recent months. You see, despite what Dave would have you think, this isn’t by any means a new concept. Peer to peer lending has been around for almost a decade now, and it has been an increasingly popular way for both cash rich and cash poor people and businesses to connect and benefit. Some of the most popular peer to peer lending sites can earn savers up to 8% interest on their investments. That’s a whole load more than you would find in any of your high street banks or building societies.

But there is a reason why these potential interest rates are so high. And the key word here is “potential”.  You see, just as you could earn a pretty penny with minimal effort on your part, you could also lose a pretty penny fairly easily too. These types of peer to peer lending schemes are not guaranteed or backed up by governments. And nor do they have the might of some of the biggest and most powerful corporate banks behind them when things go south. When you invest in a peer to peer lending scheme, you are investing directly in another person or company; and you carry all of the risks that are associated with it. You don’t have the bank there to act as a middle man as they would do in a normal savings account type situation. That’s exactly why the potential interest rates are so much higher in these kinds of setups.

So although peer to peer lending does have the ability to save borrowers money, while at the same time earning ever higher interest rates for their savers – you should always remain aware that the middle man is there for a reason. The middle man – i.e. the banks – have evolved to fill the risk void between savers and borrowers, and despite all of their recent bad press, they have actually evolved to do a pretty good job of it.

On balance, if you’re looking for a potentially high reward avenue for your savings and spare cash, then peer to peer lending could turn out to be one of the most profitable paths open to you. But as with most things financial, always remember that with higher reward comes higher risk.

Offsetting The Risk

Now that we have got the “doom and gloom” bit out of the way, let’s take a bit of a closer look at what kind of measures the major P2P lending sites are taking to try to minimise your exposure to the risky side of the deal.

For all their harmful and risky potential, peer to peer lending sites do have a number of innovative ways to spread the risk you take on when you choose to save with them. Some of the most popular P2P sites will no longer take your money and dump it all into one investment with one borrower or business. Instead, they will endeavour to split your investment up among multiple borrowers. By splitting your investment in this way, the P2P sites effectively hedge your bets for you by not putting all of your eggs into one basket. This means that if one of the businesses or people you have lent money out to fail to pay you back, then you still have the remaining deals to fall back on. This will minimise your exposure to risk, and maximise your chances of seeing a return on your investment.

As well as trying to lower your risks in the way that they handle your money and your investment once your savings are deposited, all of the main websites will of course do their upmost to ensure that potential problem borrowers don’t slip through the net in the first place. By thoroughly credit checking potential borrowers and running complete fraud and background checks on ever person and business who applies for a loan with them, the big P2P lending sites put a lot of work and effort into weeding out the problem cases before they are even allowed to develop. Many of them will pass on a full disclosure to you as an investor so that you can easily and accurately assess the type and size of risk that you could be exposed to prior to finalising your investment.

Some of the longer established players in the market have even taken this whole issue of investment security to an even more elevated level. Some of the big sites (such as Ratesetter for example) have even begun to build in an extra layer of backup plan for its investors. By putting some of their profits from successful loans aside into a communal “Provision Fund”, Ratesetter has been able to lead the way in a whole new level of peer to peer lending security. Under the “Provision Fund” scheme, any investments which turn bad and result in a borrower who is either unwilling or unable to repay the loan, all is not necessarily lost. Providing the amount loaned out is not on a massive and pre-organised scale, the funds that reside within the provision should be enough to return the initial investment back to the saver. Some of the time, savers will also find that some or all of their proposed interest is also paid out from the provision fund. In this way, Ratesetter have created a peer to peer lending environment where savers cannot really loose.

This final addition to the existing safety nets means that P2P lending has become an increasingly less risky and increasingly popular way for savers and borrowers to get together and help each other out. These sites have benefited greatly from much of the negative press surrounding banking over recent years, as they allow people to connect with each other more directly and thus cut out those fat cat bankers once and for all. And with lending to your peers becoming increasingly more secure and risk free, it’s certainly hard to see why people savers and borrowers alike wouldn’t at least look into the P2P options which are becoming increasingly available to them.