Chances are, you’ve already heard the term ‘peer-to-peer lending’ crop up in the financial news at some point. But what exactly is it, and how does this new form of investment work? Richard Litchfield, Head of Operations at Lending Works, explains how peer-to-peer works in more detail, along with some insider tips on starting your portfolio and making the best returns.
If you’re looking to start an investment portfolio, it can be tricky to know where to begin. The stocks and shares market can be complicated and intimidating, and, although there’s a lot of profit potential, the level of risk is high, especially for inexperienced investors. And while low-risk options like bonds and savings accounts might seem like a safer bet, they don’t offer much in the way of returns, with the stagnant Bank of England base rate keeping interest rates so low that a staggering 99% of accounts fail to even keep pace with inflation (MoneyExpert).
As a result, many first-time investors are now moving away from traditional forms of investment and focusing their efforts on schemes which don’t involve the stock market or big banks, and one such way is peer-to-peer (P2P) lending. Here, I’ll talk about how it works, and how first-time investors can kickstart a successful investment portfolio with peer-to-peer lending.
How does P2P lending work?
At the most basic level, peer-to-peer lending is an investment platform which connects willing investors with borrowers looking for a personal loan. The P2P platform performs the role that would be traditionally played by a bank or building society, effectively cutting out the middleman. Because of this, both parties are able to access more competitive rates, meaning cheaper loans for borrowers and better returns for investors.
The platform runs checks to ensure that all the borrowers are creditworthy, which helps to safeguard the investor’s cash. Many platforms also allow lenders to select their own borrowers, giving them some control over how much risk is taken on. The P2P platform handles the financial transaction, and the borrower pays back the loan plus interest, which the lender takes as profit.
As a lender, you can then decide whether you want to withdraw your profits or reinvest them again to maximise your returns.
What are the advantages and risks?
One of key advantages of P2P is that it offers competitive returns with a relatively low level of risk, which makes it a particularly appealing choice for those who are just getting their portfolio started. At Lending Works, investors can earn 5% per annum over a 3-year loan term, rising to 6.5% over 5 years — much higher than a traditional bond or savings account.
Of course, any form of investment which offers the potential to make decent returns is never completely without risk. But, when compared to lucrative but high-risk stocks and shares, and low-risk but low-return bonds and savings accounts, P2P offers a relatively low-risk middle ground. Each investment is diversified across lots of different loans, which means that if one borrower should default, your loss will be buffered by your other successful investments. At Lending Works, we also have the Shield — a reserve fund which serves to cover any arrears or defaults incurred by investors.
What do you need to start investing with P2P?
As with any investment portfolio plan, you’ll need a small lump sum to kickstart your portfolio. One of the key advantages of P2P is that you don’t need a huge pot of money to get started: while the exact figure varies between platforms, lenders can open an account with Lending Works from just £10, for example. You’ll also need a little bit of free time to spend managing your account, although there are a number of automated options you can use if you’d prefer to take a hands-off approach.
What can I do to make sure I get the best possible returns?
The key to maximising your returns is to keep as much money invested for the longest possible term. So, unless you need to access your money urgently, you should always opt to automatically reinvest your earnings. Given that interest rates are currently lower than inflation, any money you leave sitting in a bank account will gradually depreciate in value, so if you want to make the most of your cash, you should keep it invested for as long as you can. This way, your money is always out there working for you and gaining value.
If you’re serious about making the most of your investment, you should also consider opening an Innovative Finance ISA (IFISA). An IFISA can help you to qualify for major tax advantages on your P2P earnings: you can invest up to £20,000 of your annual ISA allowance, and any earnings this generates will be protected from Income Tax. You can read up on this in our P2P ISA guide.
If you’re looking to kickstart an investment portfolio, you should certainly consider peer-to-peer lending.