What are the risks of P2P lending?
Peer-to-peer lending is a fast-growing business in the UK, with new innovations being introduced every year. The industry has evolved tremendously from its beginnings as a straightforward money market, and now offers products to suit many different types of investor, from those looking for a more rewarding alternative to a savings account, to those seeking a safer form of investment than the stock market.
The biggest risk for investors in peer-to-peer lending is that the borrower will fail to repay their loan. This risk was initially minimised by spreading the cost of a loan across many lenders, so that a £10,000 loan would be made up of £10 loans from a thousand accounts. In this way, even if the loan goes completely unpaid, each lender only loses a small portion of their initial investment, a risk that is factored in when calculating the projected interest rates for different loans.
To help further protect investors, another more recent innovation has been introduced by the Financial Conduct Authority, which now regulates the peer-to-peer lending industry. They require each company to hold reserves of cash in order to cover bad debt, so that even if a loan goes unpaid, each investor will still receive their full loan back. These funds are created by automatic contributions from a lender’s account, so they are essentially a form of insurance.
If the company should exhaust its “safeguard fund” and be unable to repay lenders their original deposits, investors run the risk of losing their loans: to mitigate this risk, P2P lending companies maintain a fund well in excess of the amount they predict necessary (which is itself usually higher than the actual amount). Bear in mind that most peer-to-peer lenders offer accounts that aren’t covered by this repayment fund but which offer a higher projected interest rate, offering investors an option to boost their return for an increased risk.
Although the industry is now regulated by the FCA, it’s still not covered by the Financial Services Compensation Scheme (which guarantees the first £75,000 of your savings back if your bank should go bankrupt). This is something that P2P lending has in common with the stock market, but because you wouldn’t lose even a single penny unless your peer-to-peer lending company went completely bankrupt, the risks of losing your capital are much lower than trading in stocks and shares.
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