Exceptionally low interest rates might be great news for the spenders and debt-holders amongst us, but they have given savers and lenders a real headache since the banking crash of 2008. In search of greater rewards than the meagre interest rates being offered by traditional banks and financial institutions, thousands of people in the UK have turned to peer-to-peer lending. Offering interest rates significantly higher than those being offered by banks, peer-to-peer platforms have reported a burgeoning demand for their services. But what does this relatively new phenomenon entail? And is it the right investment product for you?
What is Peer to Peer Lending?
Peer-to-peer platforms allow you to invest your savings and capital by offering it as loans to ordinary consumers. Whereas the interest rates being offered by banks have been exceptionally low for some time, the returns offered by peer-to-peer lending platforms are significantly higher. There is no bank, building society or large financial institution in the middle, so the overheads associated are far lower. The platform is there merely to arrange and process the loan on behalf of both the lender and the borrower, so both end up with a much fairer deal.
Assessing Your Approach to Risk
Before you embark on your first foray into the peer-to-peer market as a lender, it is important to clarify your own attitude towards risk. According to Lendingmemo.com, you have two main positions to take as lenders. You can choose the path of ‘stability over returns’, where you concentrate your lending portfolio on borrowers with excellent credit ratings.
Your chosen peer-to-peer platform will assess the risk involved in lending to an individual or business, and communicate this to you in the form of a grade. The borrowers with good credit scores will be rewarded with lower interest rates. This gives you the opportunity to pursue a highly secure investment opportunity, but with relatively modest returns.
On the other hand, you could choose the ‘returns over stability approach’ to peer-to-peer lending. By targeting those with poorer credit scores who are willing to pay a far higher rate of interest, you can secure greater returns, but you must be willing to live with an elevated risk of borrowers falling behind with their payments or defaulting on their loans. Which approach you take will depend on your wider portfolio of investments, your need to secure a particular return, the timescale of your investment and the total amount you wish to lend.
Another option however is to let the platform manage the risk for you. Platforms such as Lending Works offer fixed interest rates to lenders by blending the rates paid by borrowers, so your portfolio is automatically diversified between higher and lower risk borrowers. For many, this approach is the most straight forward way of building your peer-to-peer portfolio.
Are You an Active or Passive Lender?
Active lenders interested in peer-to-peer lending will play an integral role in how and where their funds are used. If you take this approach, you will get the chance to select who your funds are loaned to, as well as the terms of the loans made on your behalf and how your investment fund is dispersed in order to spread the risk of lending. This may be a great option if you have time to spare and an active interest in investment markets – although you will need to learn about all the factors involved, which include credit scoring, debt management, bankruptcy law and several other related issues.
If you simply don’t have the time to spare, or you want to invest a significant amount of money, taking a passive approach to peer-to-peer lending may be a more prudent course of action. Expert lenders and individuals with an in-depth knowledge of peer-to-peer loans will take control of the day-to-day investment decisions – consulting with you on the main direction of your portfolio. You will have to entrust your capital to peer-to-peer lending experts, but this is a great way of investing large amounts over a prolonged period of time. This path may also be attractive to you if you have a wider portfolio of investments that require your time and attention.
If you are contemplating peer-to-peer lending as a way of growing your capital for the future, it may be a good idea to clarify your priorities and speak to an expert in the area before making a commitment. However, with some careful planning and the right help behind you, there is nothing stopping you making a complete success out of your first foray into the peer-to-peer market.