Lending can be a way to put your money to work and grow your wealth, but it can seem complicated and risky to beginners. Peer-to-peer lending platforms aim to eliminate some of the complexities, though many of the major risks remain. In this article we will explain how peer-to-peer lending works, what risks you need to accept before you invest and how to work out if it is the right option for you.
What is peer-to-peer lending?
Peer-to-peer lending, also called P2P lending, is a form of investing that involves lending to individual borrowers, small businesses or funding development projects, usually via a lending platform. The investor earns interest on what they lend as the borrower is paying interest on the money lent to them. This form of investing can give investors access to higher returns when compared to saving. However, peer-to-peer lending is often considered a risky investment option.
P2P lending allows borrowers to source cash away from major lenders and potentially pay a lower rate of interest, due to the lack of overhead costs associated with big loan providers. The peer-to-peer lending platform functions as an intermediary between the lender and the borrower. Its role is usually to assess the creditworthiness of prospective borrowers, send late repayment warnings and manage transactions, amongst other tasks. The provider will retain a share of the interest paid by the borrower in exchange for arranging the loan.
How does P2P lending work?
To invest in peer-to-peer lending, you will need to select a P2P platform, register and transfer the funds you wish to invest. It is possible to use an ISA to invest through P2P lending via an innovative finance ISA, or IFISA. Depending on the platform, there will be different decisions to be made at different stages of the process. You will need to agree to a fixed rate of interest that the borrower or borrowers will need to pay on the loan and how long you would like to lend the money for. This period will usually be one to five years.
Some providers will present a selection of prospective borrowers for you to choose from. These could be individuals, small businesses or projects to invest in. Other providers will split your loan up across multiple applicants, in order to lessen the risk of a total default. Either way, with most providers you should be able to pick an option that suits your appetite for risk and investment timeframe.
By the end of the loan term, all of the money should be repaid and you should have the original amount you lent back, plus interest. You can then withdraw the money or reinvest it in a new P2P loan.
Peer-to-peer lending risks
The money you put into a peer-to-peer lending platform is not protected by the Financial Services Compensation Scheme (FSCS). This means that there is a possibility you could lose some or all of your money. The main risks to think about when it comes to P2P lending are defaults, early or late repayments, and providers going bust.
Borrower defaults
The most obvious risk with lending money in any context is the danger of the borrower not paying you back. This is called defaulting and is an important scenario to consider before you invest in P2P lending. Some platforms will set up contingency funds to cover your investment if this were to happen, but their usefulness will vary from provider to provider. This means it is very important to find out how your chosen provider deals with defaults before you commit any money.
Late (or early) repayments
While some loans are not paid back at all, others are just paid back late. This is less of an issue, but could still mean you lose out on money in the short term. Early repayments can also be a problem, as a borrower will have the right to pay back their loan early and save money on interest. This would mean the lender would get a smaller return. However, getting your money back early can mean you are able to reinvest it in a new P2P loan sooner and continue to earn interest.
The P2P site going bust
This will be a risk that investors with some knowledge of the P2P world will be very conscious of, as multiple providers have gone bust in the past. Peer-to-peer lenders in the UK should be regulated by the Financial Conduct Authority (FCA) and must ensure any money invested is kept in a ring-fenced account, separate from its own funds. If the provider goes bust, your money should be safe with a third party.
The loan itself is between the lender and the borrower, so a peer-to-peer lending platform going bust will not write off that debt. If the provider does go under, another platform could pick up the customers of the one that has folded. It will not be a simple process and could stretch on for a long time, so it is something to be wary of, even if it would not necessarily spell total disaster.
Tax on P2P lending
Most gains made through a peer-to-peer lending investment will be classed as taxable income and contribute towards the personal savings allowance. For the 2024/25 tax year this was £1,000 for basic rate taxpayers, £500 for higher rate taxpayers and £0 for additional rate taxpayers. Any money earned beyond these limits - across all of your non-ISA savings - will be taxed at the highest marginal rate applied to your other income, assuming your total income (including savings and investments) exceeds the personal allowance of £12,570. This means a basic rate taxpayer earning more than £12,570 would pay 20% tax on their savings income over £1,000 and a higher rate taxpayer would pay 40% tax on their savings income over £500.
One exception to this is if your P2P lending account is part of an ISA. This can be done through an Innovative Finance ISA (IFISA) and means any interest you earn will be tax free. Keep in mind that any money you invest will form part of your ISA allowance. This is £20,000 for the 2024/25 tax year and applies across IFISAs, cash ISAs and stocks and shares ISAs
The different types of peer-to-peer lending
Investing through a peer-to-peer lending platform can broadly be divided into three groups.
The first involves lending to an individual and is the simple process of selecting an applicant you want to lend your money to. You should be able to see their credit score or a level of creditworthiness prescribed by the P2P platform.
The second P2P option is to lend to a small business. This could be to help get the company up and running, to fund an expansion or to cover day-to-day costs. In some cases this type of peer-to-peer loan can come with a personal guarantee from a director of that business for extra security. This means that if the business fails or cannot repay the debt, the named director will be liable.
The final peer-to-peer group is project lending. This involves your money going towards specific development projects, such as building new housing. For this option, as an added layer of security, your loan is often secured against whatever is being constructed.
What are the pros and cons of peer-to-peer lending?
Here are the main pros and cons of peer-to-peer lending that you will need to consider before you invest.
Pros of peer-to-peer lending
- Relatively high earning potential - You will likely be able to get a higher rate of return on your investment than if you put the same amount of money in a savings account.
- Borrower defaults do not have to be catastrophic - There are some safeguards in place to protect investors from borrower defaults. These can include providers setting up contingency funds or borrowers securing assets against the loan.
- Regulation protects your money if providers go bust - FCA regulations state that P2P platforms must ring-fence your investment from its own assets, so your money should be protected if the firm goes bust. Your loan should also continue, as your agreement is with the borrower.
Cons of peer-to-peer lending
- Your money is at risk - All of the money you put into the P2P platform is at risk. While some providers will have mitigation plans in place should a borrower default, there is no guarantee that it will have the cash to cover your investment if things go south.
- Your money will not be easily accessible - The nature of peer-to-peer lending is such that getting your money in a hurry is difficult. The funds you invest will go to someone else until it is repaid, so if you need that cash back in an emergency, you will likely need to pay a hefty fee.
- Early repayments could cost you - Your borrower or borrowers will have the right to repay their loan early if they can. This will save them money in interest charges, but it will mean you miss out on the full amount you expected to earn.
How to choose the best peer-to-peer lending option
The most important part of building a P2P investment plan is to make sure your platform is correctly regulated. You should check this by searching for the company on the FCA Register.
Once that is confirmed, you can think more about the details of your investment, specifically:
- Your appetite for risk - Peer-to-peer lending is riskier than a savings account, so make sure you are comfortable with potentially losing a significant amount, or all, of your money before you commit.
- The amount you are investing - There will be a minimum and maximum amount that a P2P platform will accept, so make sure your plans fit with your chosen provider’s limits.
- How much you are charged in fees - Some P2P providers will charge platform or management fees, while there will also likely be costs involved if you try to access your money before the end of the agreed term.
- The borrowers you are lending to - Look closely at the lending options offered by your chosen peer-to-peer provider. High credit scores generally point to a more reliable borrower who can be trusted to repay your cash on time.
What are the alternatives to P2P lending?
Here are the main alternative options to consider if you decide that peer-to-peer lending is not for you.
Stocks and Shares ISAs
Investing through a Stocks and Shares ISA allows you to put your money into a range of different assets, with the added benefit of the ISA tax wrapper. You get to pick and choose the right option for your investment plans. Some providers will make all of the key decisions for you, while others will allow you to micro-manage the details of your investment. Like with peer-to-peer lending, your money will be at risk when you invest with a stocks and shares ISA. You can learn more by reading our article 'What is a Stocks and Shares ISA?'.
Cash ISAs
A Cash ISA functions in a similar way to a traditional savings account, but the money you save is tax free. What you put away earns interest over time to boost the total value of your savings pot but, unlike with a Stocks and Shares ISA, a Cash ISA has a guaranteed interest rate and your money is protected by the FSCS. This protection means that your savings are guaranteed up to £85,000 per banking group if your provider goes bust. Cash ISAs are, therefore, a much safer option than Stocks and Shares ISAs or innovative finance ISAs, but you are less likely to earn a high return on your money. We explain more in our article 'What is a cash ISA?'.
Pension
It can be easy to overlook a personal pension when it comes to considering investment options. However, through a Self-invested Personal Pension (SIPP), you can flexibly invest the money you want to put towards your retirement. A SIPP works in a similar way to investing through a Stocks and Shares ISA, with the main difference being that you get income tax relief on your contributions, but on the flip side, pension withdrawals are taxable. If your investment plans involve funding your retirement, a SIPP can make much more sense than any other investment account. We cover the details in our article 'What is a SIPP and how does it work?'.
