Have you ever wondered what happens when people lend money to each other without involving a bank? This is the idea behind peer-to-peer (P2P) lending. The concept is simple: all you need is to lend money directly to other people or small businesses through an online platform.
According to recent data, Global P2P lending is expected to reach nearly $500 billion by 2027, thanks to better credit checks, easy-to-use platforms, and rising demand. But while this sounds like a big opportunity, it also brings big risks. Here, we have gathered the pros and cons of peer-to-peer lending in the UK.
What is Peer-to-Peer Lending?
The idea of P2P lending comes from cutting out the middleman, which is the banks. People just use online peer-to-peer lending platforms to lend their money. No banks are involved in any step of the lending process.
As it connects lenders and borrowers directly, there are lower costs than with a traditional lender. As a result of this, lenders can earn higher interest rates while borrowers pay less.
However, peer-to-peer lending platforms in the UK do not stop controlling. They still check borrowers, handle payments, and follow up on late repayments. In return, they pay a small fee.
In the picture, this system can be good for both sides. But in practice, it can be riskier than keeping money in a bank for lenders.
How Does P2P Lending Work?
Initially, it is best to start by knowing that there are many P2P lending platforms available in the UK, and you can choose whichever you want. Here is what you need to consider:
- Each platform offers different lending options. These come with different risks, interest rates, and rules for taking out your money early. For example, you might lend money for 2 years at a fixed rate, but if you want to take it out early, the platform could charge a 1% fee.
- Be aware that some platforms let you pick your borrowers, but most will spread your money across many loans. This usually helps reduce other risks. In simple terms, if one borrower does not pay, the others still might.
- Compare your options carefully, do your research, or even talk to a financial adviser, so you know what you are signing up for.
Before starting, you need to sign up for the platform you choose and add your money to your account. At this step, you can use either your debit card or by bank transfer.
Then, you need to decide how long you want to lend your money. Generally speaking, it can be between 1 and 5 years. Later, you have to agree to an interest rate. This will be an indicator of how much profit you will make.
Once the time is up and the borrower has paid you back, you can take out your money or lend it again.
Peer-to-Peer Loan Example
Imagine you want to invest some money and earn a better return than a savings account. You decide to try peer-to-peer loans.
First, you sign up for a P2P lending platform online. You add £500 to your account using your debit card or a bank transfer. At the same time, someone else applies for a loan through the same platform. They might need to borrow money to buy a used car or pay for home repairs.
The platform takes your money and lends it to that borrower. In return, the borrower repays the loan over a set period. Let’s say 3 years with 5% sufficient interest.
Each month, the borrower makes repayments. A portion of that comes back to you as a mix of your original money and interest earned. By the end of the 3 years, you will receive your £500 back, plus more money from the higher rates.
P2P Lending Advantages and Disadvantages
Now that you have fully understood the basics of P2P lending in the UK, it is time to move on to the advantages and disadvantages of this concept.
Advantages of peer-to-peer lending
- You can earn more interest than a regular savings account.
- Each P2P loan platform is Financial Conduct Authority (FCA) regulated.
- Most P2P platforms are online and easy to set up.
- You can lend directly to people or small businesses without any bank involvement.
- You can choose how much to lend and for how long.
- You can often receive regular payments with interest.
- Your money is usually spread across many loans to lower risk.
- You can earn interest tax-free thanks to the personal savings allowance.
- Your money can help real people or businesses who need loans.
Disadvantages of peer-to-peer lending
- Borrowers might not pay you back.
- Your money is not covered by the Financial Services Compensation Scheme.
- If peer-to-peer platforms shut down, it may be hard to get your money back.
- You may not be able to withdraw money early without a fee.
- You might earn less than expected, especially if there are defaults.
- Some platforms charge fees for early withdrawal or managing loans.
- In a downturn, more borrowers may fail to repay.
- You often do not know exactly who is borrowing your money.
Top 6 Risks of P2P Loans
Below, we have explained the possible risks that you might encounter while borrowing money through online platforms.
1. Fraud Risks
Even though P2P platforms check borrowers’ details, fraud can still happen. Someone might try to trick the system to get money they do not plan to repay. For example, a borrower could use false information to get a loan, or a fake company could pretend to be a real business.
If it happens to you, as a lender, you could lose some or all of your money.
2. Early or Late Loan Repayments
Sometimes, borrowers might repay their loan earlier or later than expected. If they pay early, you may stop earning interest sooner than planned.
If they pay late or miss payments, you might wait longer to get your money back, or you might lose some of it. This can affect your returns and make it harder to plan your finances.
3. Losing Money
In P2P lending, there is always a chance you could lose money. If a borrower does not repay their loan, you might not get back the full amount you lent.
Even if your money is spread across many loans, some could still fail. Unlike a bank savings account, there’s no government protection, so any losses come out of your pocket.
4. Less Profit over the Interest Rate
The interest rate shown on a P2P platform is not always what you earn. Fees, late payments, and borrower defaults can all reduce your profit.
So, even if the platform says you’ll earn 6% interest, you might end up with less after costs are taken out. It is important to remember that the final return can be lower than expected.
5. Additional Fees
Some peer-to-peer lending platforms charge extra fees that reduce your earnings. These can include setup fees, account management fees, or charges for withdrawing your money early.
Although the interest rate looks good, these fees can lower your final profit. Always check the fee details before investing.
6. Lower Interest Rates
Sometimes, the interest rates can be lower than expected. This can happen if the platform attracts safer borrowers or if the market changes.
Lower interest means you earn less money from lending. So, do not always expect very high returns. Sometimes, the profit can be closer to traditional financial institutions’ rates.
How to Pay Tax on Peer-to-Peer Lending?
When you earn money from peer-to-peer lending, it is usually treated as income and may be subject to tax. However, many people will not have to pay any tax because of the personal savings allowance.
According to this, you can avoid paying taxes up to £1,000 in interest income if you are a basic taxpayer. On the other hand, if you are a higher-rate taxpayer, you have an income tax allowance of up to £500.
If your interest earnings go beyond this allowance, the extra amount will be taxed at your highest income tax rate.
There’s also a special type of savings account called an Innovative Finance ISA (IFISA), where you can hold your P2P loans. Interest earned inside an IFISA is completely tax-free, and you do not need to report it to HMRC.
Note that you can put up to £20,000 into all your ISAs combined each tax year, including IFISAs.
What is the Difference between Crowdfunding and Peer-to-Peer Lending?
When comparing crowdfunding and peer-to-peer lending, the first thing you need to learn is the type of investment. P2P lending is a loan-based investment, which means you lend money and earn interest. Crowdfunding is more equity-based. You invest in a business and own a small part of it.
As a reflection of this, P2P offers fixed interest rates while crowdfunding returns depend on business performance, and your return can vary according to that.
Besides, P2P loans have fixed terms, and you can get repaid by a set date. In crowdfunding, you do not have a fixed end date. You simply choose when to sell your equity.
In P2P, there is no direct relationship with the borrower. The platform handles checks. On the contrary, borrowers pitch directly to investors, and the relationship is more personal through crowdfunding.
As a borrower, you can pay interest and keep ownership in P2P. In crowdfunding, the borrower gives up part of the business.
When it comes to risks involved, if the project fails, the borrower must repay the loan amount with interest, or they risk losing their collateral. In crowdfunding, there is no guaranteed return. If the business fails, investors may lose their money.
How Can I Stay Safe When Using P2P Lending Platforms?
To avoid scams in peer-to-peer lending, you should always use regulated platforms approved by the FCA in the UK. Plus, you can avoid deals that sound too good to be true or promise very high returns with no risk.
Moreover, you should check if the platform does proper credit checks and spreads your money across multiple loans. Also, we recommend you read the terms carefully and never send money directly to borrowers.
FAQs on P2P Lending
Is peer-to-peer lending worth it?
It can be, if you are willing to take some risk for higher returns than a savings account. Always research first.
What happens if you don’t pay back a peer-to-peer loan?
You may face extra fees, damage to your credit score, and legal action from the platform.
Is a P2P transaction safe?
It can be safe if done through a trusted, FCA-regulated platform. But your money is not protected like a bank account.
Can I cancel a P2P payment?
No. Once the payment shows in your “transaction history,” it has been accepted and can’t be cancelled or changed.
Can I get my money back if I send a P2P payment to the wrong person?
Usually not. If the wrong person accepts it, it is very hard to recover the money. Always double-check details before sending.
