New peer-to-peer companies are being created without proper checks and balances put in place, say more established businesses. Here's how you can protect your cash and make a decent return.
Savers seeking a healthy return on their money have been flocking towards peer-to-peer (P2P) companies this year due to the dismal rates on offer from the high street banks.
Peer-to-peer companies offer returns of around 5%, which is far higher than a traditional savings account, leading to a huge surge in people using them.
But several new start-up companies have sprung up and many do not have procedures in place to safeguard savers’ money.
P2P popularity
Zopa, Funding Circle and RateSetter are the three biggest players in this market and savers have poured in almost £600million into these three companies in an effort to secure a decent return.
These websites work by cutting out the middle man – the bank – and making loans cheaper for borrowers and giving higher returns to savers.
The main reason for the fall in rates at the banks is the Government’s Funding for Lending Scheme (FLS), which came into force around a year ago and gave providers cheap access to cash. This lessened the demand for customer deposits and sent savings rates crashing down to an average of around 2%.
Now the P2P companies have gained so much momentum that it’s expected they will be included under the tax-free ISA umbrella at some point next year.
The rates on offer are attractive, averaging around 5% from the main players. But smaller companies are offering much higher returns, such as 12% from eMoneyUnion and more than 9% at P2P Credit. However, with rates this high, there are also higher risks attached which savers may not be aware of.
Stuart Law, chief executive of P2P company Assetz Capital, which lends to property constructors and small businesses, says the main problem is that newer companies are in a rush to get started.
"The latest entrants are playing catch up and some are very lightweight. It's hard to get started without substantial investment," he says.
Lack of regulation
The problem with this industry is that it is currently both unregulated and not included in the Financial Services Compensation Scheme (FSCS) which covers up to £85,000 of deposits with any one financial institution. This means companies can easily be set up but there are no safeguards in place to make sure the money invested is protected.
In fact the only type of regulation in place is self-regulation via the Peer-to-Peer Finance Association, but the only members of this body are the three leading companies.
However, this is all set to change next April when regulation is put in place. This will be a positive step for the industry as all companies will be made to comply to a certain set of standards.
[SPOTLIGHT]Giles Andrews, co-founder of Zopa, says: “Regulation will help protect consumers against irresponsible lenders and strengthen trust between consumers and P2P lenders that have a proven track record.”
However, many start-up companies won’t be able to afford the process of regulation and therefore will be forced to close.
The danger here is if a company is forced to shut down because the costs of regulation are too high, there is a risk to the cash already invested.
If the company has been set up effectively and has correct procedures in place to protect savers' cash there shoudn't be a problem. But if the company hasn't set this up there could be a potential risk to any money held within it.
Therefore until April it's important you think carefully about who you deposit your money with.
P2P checklist
Before you start lending through a P2P company there several things you should ask yourself before parting with your cash.
Are there accurate checks in place for borrowers?
Responsible lenders will have measures in place to make sure borrowers have gone through the same credit check banks use.
Some companies will also require borrowers to provide one or more tangible assets as security, such as a property, because written guarantees can sometimes be ineffective.
Is your cash in a diversified portfolio?
With any kind of investment, diversification is key to minimising your overall risk. When you lend out money through a P2P company, the loan should be split between different borrowers, therefore lowering the overall risk of a loan defaulting.
Samir Desai, CEO and co-founder of Funding Circle, says this is one of the most important things to look at before investing in a P2P company.
“The key question people should ask themselves is whether they can spread their money across hundreds of businesses. This will ensure they are well diversified and any small losses they experience will have no significant impact on their overall investment,” he adds.
What's the default rate?
The default rate of people borrowing from a website should be shown and this will give you an idea about how well it’s managed and the risks involved.
Zopa, for example, has a bad debt rate of 0.23%, whereas at Funding Circle it’s a slightly higher 1.5%. On the whole websites offering returns of 10% or more will be lending to riskier borrowers and therefore the chance of a loan defaulting is higher.
Can I be paid if a loan defaults?
If a company has set up a provision fund this means lenders’ money will still be paid out even if a borrower defaults on a loan.
Rate Setter, for example, currently has a provision fund of over £1.4 million to cover any losses. Having said that, it has £64 million out on loan so even the fund isn’t a cast-iron guarantee.
Is savers' money kept in a separate cash fund?
Another measure to check is if the cash you’re investing is kept in a separate fund. This is a good idea as it puts another ring around your money should anything go wrong.
At Assetz Capital, for example, savers’ cash is kept in a fund operated independently by Grant Thornton so the company can’t access it.
“Be sure that any P2P company you lend to has a similar procedure in place – if not, it the company could use your money for its own purposes,” says Assetz's Stuart Law.
How transparent is the company?
Any P2P company should have a clear and transparent website listing off how much money has been invested through the site. This gives you an indication of the size of the company and its success rate.
Most websites also include the company's credit history and have an open forum where you can chat to other investors and ask questions, which should also give you more information about the company in question.
Are you depositing money with smaller P2P websites? Do you think these types of websites are too risky? Let us know in the Comments box below.