Peer-to-peer lending: what you need to know about P2P risk

Investors can get invest tax-free in peer-to-peer (P2P) via Innovative Finance ISAs for tempting returns, but this can be risky – here’s why.

Innovative Finance ISAs (IFISAs) are catching the attention of potential investors and it’s not hard to see why given the juicy headline rates on offer.

IFISAs contain assets such as peer-to-peer (P2P) loans, or investments, which tend to target returns of between 4% and 12%.

But before rushing to sign up, you need to be aware of the potential dangers.

IFISAs may be worth considering using to get involved in peer-to-peer lending, but this is not risk-free.

We asked several financial experts about what to look out for when considering peer-to-peer lending – and how to decide if the potential rewards are worth the risk.

Or you can jump straight in and compare P2P investments (capital at risk), Cash ISAs and traditional savings accounts with loveMONEY here.

Why investors are drawn to P2P

IFISAs, which adds a tax-free wrapper to savings income from peer-to-peer lending, are available to those aged 18 or over.

Peer-to-peer lending is best described as a way of matching investors with borrowers, who could be individuals, businesses or even property developers.

The allure of peer-to-peer lending is that you may potentially earn higher returns compared to interest rates from mainstream savings accounts.

There are plenty of IFISAs on the market you can open from as little as £20 to get involved with peer-to-peer lending, with targeted returns over five years as high as 12% per annum in some cases.

Innovative Finance ISA: what it is, how it works, rates and providers

‘No track record in challenging markets’

It’s a mistake to compare P2P products with bank accounts, stresses Patrick Connolly, a chartered financial planner at Chase de Vere, as they are fundamentally different.

“People need to understand it is an investment and not a savings account,” he says.

“There will be some instances where they go wrong.”

This is particularly the case for the burgeoning peer-to-peer market, as some of these investments may not yet have a track record in challenging markets.

Connolly also highlights P2P lending isn’t covered by the Financial Services Compensation Scheme (FSCS) despite being regulated by the Financial Conduct Authority (FCA).

“If a borrower or provider defaults, those who invest could be left out of pocket,” warns Connolly.

“This lack of protection means these investments are unsuitable for those looking for security.”

Compare traditional investment options at loveMONEY (capital at risk)

What are the investment risks?

Similar to most investments, there is definitely some risk with peer-to-peer lending.

According to Adrian Lowcock, head of personal investing at Willis Owen, it is the same question that applies to most investments: will my money be returned with interest?

“The issue for investors is that it can be very hard to fully calculate this risk and, therefore, judge whether or not the P2P investment is a good one,” explains Lowcock.

On the face of it, a higher return would imply more risk is being taken.

But Lowcock points out that it’s not quite so clear cut.

“It doesn’t mean lower rates aren’t risky,” he says.

“If a business is complex, the risks may be well hidden and, therefore, not fully factored into the returns being offered.”

This may result in a nightmare scenario of getting involved with a higher risk investment with lower returns.

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‘Higher returns and higher risk’

The link between risk and reward is pretty much unbreakable says Martin Bamford, managing director at Informed Choice.

“If you chase higher returns, then your risks are greatly increased,” warns Bamford.

Yet, the issue is that the risk-reward discussion follows a non-linear curve.

“When the Bank of England rate is 0.75%, the ability to obtain more than four times that return means exposing your capital to far more than four times additional risk,” he says.

Bamford warns investors are often misled by the promise of an ‘interest rate’ as a return, which might not be realised.

“Investors might consider a small allocation to well established P2P firms but should take great care not to invest more than they can afford to lose,” he says.

Patience is also required.

“They need to be prepared to wait for extended periods of time to gain access to their capital, especially during a period of economic downturn.”

Is peer-to-peer investing right for you?

According to Lowcock, whether or not peer-to-peer investing is right for you will depend on your circumstances.

If the money is coming from your much-needed savings, for example, then it’s probably not the best idea.

“If you are investing in P2P, then the key issue is to make sure you have a diversified portfolio of different investments and don’t chase the higher yields as they mean higher risk,” he warns.

You also need to do your research.

“Check the company is listed at Companies House and research the names of the directors,” adds Lowcock.

Scott Gallacher, director of Rowley Turton, agrees you need to look closely at potential investments.

He cites the easyMoney Innovative Finance ISA.

“The easyMoney ISA loans are bridging finance and property development secured by first charge on the properties,” says Gallacher.

“This should reduce risk of capital loss but doesn’t remove it completely.”

As some predict Brexit could result in a severe recession and house prices falling 30%, Gallacher suggests P2P investing could be severely tested in the near future.

“For me, 4.05% isn’t enough to justify the risks or the lack of FSCS protection,” he says.

“I’d prefer the certainty and security of a traditional deposit.”

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'No free lunches'

Ben Yearsley, director at Shore Financial Planning, is clear.

“The simple rule of thumb is the higher the rate of return on offer, the greater the risk to your capital,” comments Yearsley.

“There are no free lunches.

“I’ve been concerned that many think they are cash substitutes with easy access.

“This is partially down to some of the marketing campaigns that have been pretty poor.”

Any time you’re getting a return higher than cash, he warns, you will be risking some – or all – of your capital. It’s something that must be remembered.

Compare investment options at loveMONEY (capital at risk)

“If you are being offered 7%, the company borrowing the money is probably paying 10% or more,” says Yearsley.

“That’s expensive money and makes the risk of failure higher.”

Of course, that’s not to say that peer-to-peer lending via IFISAs should be ignored completely.

Yearsley is a bit fan of IFISAs and has incorporated them into his own tax planning for three years.

Yet he only considers them when the company to which he is lending money has assets backing up the loan – and when investors have first charge over that loan in the event of a default.

Those assets are often property.

“While this doesn’t guarantee your investment, it helps underpin it – and of course you only need that if the company gets into financial difficulties,” he says.