As peer-to-peer platforms offer the potential for high interest rates, it pays to be aware of the pitfalls of lending your money on them.
There’s Good Money To Be Made Lending On Peer-To-Peer Platforms Providing You’re Aware Of The Issues
Whilst Lending On Peer-To-Peer Platforms Is A Great Story, It’s Not Without Risk
In recent years, the interest you could have earned from lending your money on peer-to-peer platforms has been higher than the interest rates being paid by bank and building societies. By all accounts, the growth in peer-to-peer platforms has been fuelled largely from the migration of money from these deposits. But they are very different beasts.
Deposit based investments are guaranteed up to the first £85,000, covered by the Financial Services Compensation Scheme. There’s currently no such guarantee if you lend your money on peer-to-peer platforms.
The highest interest rates earned on peer-to-peer platforms are generated from lending your money to businesses. And as SIPPs and SSASs can primarily only lend to businesses, it’s on this area that we focus.
Peer-To-Peer Platforms Are Filling A Lending Gap
Whilst banks have been lending to businesses for decades, even with Government initiatives, banks are not lending in the volumes they used to. This lending gap has opened up the market for peer-to-peer platforms.
Banks make big money from lending, but they aren’t about to let that profit stream disappear to the peer-to-peer platforms. The banks’ reduced level of lending is partly due to the fact they’re applying more stringent underwriting criteria. But a lot of it is because many of the business proposals they’re being offered simply don’t stack up. As a result, they’re happy for the peer-to-peer platforms to pick up the loans they’ve rejected. For this reason, you should be extra careful you’re not taking an unnecessarily high risk when you expose your money to business lending on peer-to-peer platforms.
To help you profit from this ever-increasing source of high interest, in no particular order, here are seven areas to consider when you lend your money on peer-to-peer platforms.
1. Don’t Be Hoodwinked By The Interest Rates
The advertised rate on peer-to-peer platforms is not necessarily the rate you’ll secure on your loan. Your interest rate depends on the exact rate at which you choose to lend, the risk grade of the businesses to which you lend, and any losses you might suffer. For these reasons, basing your decision to lend on historical statistics is a dangerous game, because just like investments, past performance is no guide to future interest rates. As the market grows, it’s inevitable that interest rates will reduce. This can be perfectly demonstrated by looking at the rates currently being quoted by the largest, most established peer-to-peer platforms, compared to the rates that were achieved through them in years gone by. If you end up only making a modest return, you need to consider whether you’re making enough money to put your capital at risk, compared to other lending and investment opportunities.
2. Beware Of Where The Real Financial Risk Lies
When loans fail, be under no illusion that it’s your money, and not the peer-to-peer platform’s money at risk. It’s fair to say a peer-to-peer platform will damage its reputation if many of its loans fail. But it has a strong profit motive for accepting many loans, and that means its interests and yours are not well aligned. It’s possible that some deals may be listed when perhaps the prudent thing might be for them to be refused. Questionable lending was one of the big contributory factors to the financial crash of 2008.
3. Understand What Happens When Loans Fail
Some peer-to-peer platforms have created funds to bail out borrowers in the event that things go wrong. That’s a good thing. But this money doesn’t come from the peer-to-peer platforms. You are paying for this ‘insurance’ by way of a lower interest rate. So if some loans fail, and sadly some will, make sure you understand exactly what process will be followed to recover your interest owing and your loan capital. As it’s often an independent firm who will be fighting for your money on your behalf, it’s worth knowing how they’ll be paid, in order to prevent you losing a big slice of your money covering its costs.
4. The Importance Of Due Diligence
Relying solely on the credit rating of a loan assessed by the peer-to-peer platform can be risky, as the peer-to-peer platform has a vested interest in listing as many loans as possible. Nowadays, the internet makes it very easy to do your own investigations, which you should do in every case before you part with your money. Search sites like duedil.com and Companies House, obtaining copies of accounts wherever possible. Check the business’ website and search forums for any adverse publicity. Check out the key people running the business through LinkedIn and other relevant industry focused sites found through Google. Quite simply, if it doesn’t feel right, don’t lend.
5. Get To Grips With The Risk Reward Ratio
There are two schools of thought here:
- (i) If you spread your lending over many loans, you’re likely to reduce your risk. But it’s also likely your net interest rate will be reduced too.
- (ii) If you focus on the higher earning deals, making larger loans in the process, you can reduce your risk if you carry out a much high level of due diligence. But if things go wrong, your losses could be higher.
This is no different to the way you might approach stockmarket investment. It’s covered in this article on compound interest in which you’ll see that Warren Buffett favours the second approach.
6. Protect Your Lending With Additional Security
When a business loan goes wrong, you often don’t just lose your interest, you can lose your loan capital too. Wherever possible, make sure your loans are secured, ideally with first charges on real assets. If you have to accept a second charge, ensure there is plenty of equity available in the asset, for if it has to be sold quickly, it’ll rarely achieve its true market value. And that could leave you holding a worthless charge.
7. An Important Word About Taxation
When you lend personally on a peer-to-peer platform, not only do you pay tax on your interest, you also cannot offset your losses against interest income for tax purposes. If you lend on a peer-to-peer platform via a SIPP or a SSAS, it’s a very different matter. Tax relief on your contributions could boost the amount you have available to lend on the peer-to-peer platform by 45% (the highest Income Tax rate in 2014/15). And you’ll earn your interest tax free. On a like-for-like comparison, pension lending on peer-to-peer platforms is significantly more rewarding than lending personally.
Lending On Peer-To-Peer Platforms Is Definitely Worth Considering
Having highlighted the pitfalls of lending on peer-to-peer platforms, it’s worth stating there are many positives. For more information on lending on peer-to-peer platforms with a SIPP or a SSAS, you’ll find some useful resources on our peer-to-peer page.
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Crowdfunding And Peer-To-Peer Risk Warning
When a platform has been assessed and approved by a SIPP or SSAS operator, this does not imply that any loan or investment opportunity is endorsed in any way. A SIPP or SSAS operator's due diligence review is limited to ensuring the processes and procedures of the platform are in line with both FCA and HMRC principles. It's entirely your responsibility for carrying out your own due diligence on any loan or investment opportunity before agreeing to lend or invest your pension money on a platform. As a SIPP or SSAS operator will continually review platforms from a regulatory perspective, it's possible for a platform to become 'unapproved' if something changes.
With peer-to-peer lending, your capital is at risk if you lend to individuals and businesses. You may lose some or all of the capital lent if the borrower defaults and is unable to meet its liabilities. Historic loan default rates are not necessarily indicative of future default rates. In addition, lending is an illiquid investment, which means you may not be able to access the capital you lend for the duration of the loan period, even if the platform offers a secondary market. Investing in any business involves risks, including illiquidity, lack of dividends, loss of investment and dilution, and it should be done only as part of a diversified portfolio. Crowdfunding is generally targeted at investors who are sufficiently sophisticated to understand the risks and make their own investment decisions, based on their knowledge, experience and financial capacity. Neither crowdfunding nor peer-to-peer lending is covered by the Financial Services Compensation Scheme. The tax treatment of your investment is dependent on your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of crowdfunding investment or peer-to-peer lending, you should consult a suitably qualified independent financial adviser.
As SIPPclub neither advises on, nor arranges, nor recommends specific investments or strategies, we're unable to say whether a SIPP or SSAS or any investment within it is right for you. Ultimately, it’s your money and your decision, and you should only proceed once you're satisfied you've undertaken sufficient due diligence. If you need advice, you should speak to your trusted adviser, or you could find a local adviser from Unbiased.co.uk. Alternatively, we'd be pleased to introduce to a suitably qualified independent financial adviser.
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