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Open your eyes before you start peer-to-peer lending

Model people connected by lines

Peer-to-peer lending websites can give people much-needed affordable loans, while also rewarding lenders with decent returns. But this comes with a higher risk that you need to be willing to take.

I like the idea of peer-to-peer lending (P2P) websites, like Zopa and Quakle, which enable savers to make loans to other individuals and to small businesses.

Depositors get a better rate on their nest egg than the poor interest rates offered by high street banks, while borrowers can access loans that are either unavailable or prohibitively expensive elsewhere.

And yet, it isn’t as straightforward as that and the lack of public discussion around the risks involved is worrying.

Make or break

The good news is that if a peer-to-peer lending site goes bust, chances are that another company will step in to manage the existing loans book. Your loan is to another individual or small business, with the P2P site acting only as go-between.

However, it could be a different story if you’re a saver. As times get harder for many, unemployment creeps up and wages are frozen, the number of borrowers defaulting on their loan repayments is likely to increase, reducing the return you get on your savings.

In fact, if you lend to riskier individuals, you may be putting not just your returns, but also some of your capital at risk. And the safety net of the Financial Services Compensation Scheme (FSCS) doesn’t apply to peer-to-peer lending.

Investing, not saving

And that is the problem with peer-to-peer lending websites. I’ve used the words ‘savings’ and ‘savers’ above, but this is a misnomer – lending your money to other consumers is not saving, it’s investing.

And in much the same way as you can get higher returns by putting your cash into corporate bonds (i.e loans to companies), so too must you accept a higher risk.

Too many cautious consumers currently receiving pitiful rates on their savings risk jumping into peer-to-peer lending without understanding the increased risk they are running.

If you’re happy with this higher risk, peer-to-peer lending can offer the informed individual a route to higher returns than savings, but only as part of a balanced portfolio. And only if you know what you’re investing in.