Peer-to-peer lending comes as two models – lending or investment.
Lending is to businesses, to ease cashflow or finance stock or capital spending, or to individuals, generally for big ticket items like buying a car or home improvements.
Another lending niche is making cash available to property developers.
Investment is taking a debt or equity stake in a business in return for cash.
Debt is repaid as a loan by the business, while equity is funded by growth in share prices.
Crowdfunding platforms pair investors and borrowers.
Understanding P2P risk
They promise to work out the risk by assessing the creditworthiness of borrowers. How this works can vary between platforms, but most will grade borrowers according to risk and assign a rate of interest to them.
Some platforms allow lenders to set their own minimum interest rates, but if this fails to match the credit assessment, they may have to wait for the market to rise before anyone considers a loan with them.
Interest is paid according to the loan contract – typically monthly for individuals and small businesses.
The capital is repaid at the end of the loan term.
Investors taking a crowdfunded equity stake have a different model to follow.
Their shares are valued at the start of the investment, but as most start-ups or businesses offering equity are private, there is no secondary market to dispose of them. The typical exit is for the company to be swallowed by a larger entity or to go public on the London Alternative Investment Market (AIM).
Although most investors would consider the risk of peer-to-peer (P2P) lending defaults as higher than bank borrowing, data shows this is untrue. The default rate was found to be 2.07% in 2016 by a Cambridge University survey.
A point to watch is P2P lending is not covered by the Financial Services Compensation Scheme, the government-backed financial compensation agency.
Any cash staked in P2P lending has the potential to be lost with any chance of recovery, so even though the default rate is low, if an investor has the bad luck of a borrower who can’t repay the debt, the only option is probably chasing the money through the courts.
Any interest or capital gain in share growth from peer-to-peer lending is taxable, although tax-free bandings will apply. Some P2P investing can be held in alternative finance ISAs.