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Why does peer-to-peer lending offer such high interest rates?

Posted on 02/11/2018, by Joe Jones

With interest rates having been at historic lows for the best part of a decade, investors remain on the lookout for ways to make their money work harder.

One of the increasingly popular alternative asset classes is peer-to-peer (P2P) lending. According to the UK Peer to Peer Finance Association, around 150,000 UK investors have now funded close to £9bn of P2P loans in recent years.

What is P2P lending?

P2P lending is a technological twist on one of the world’s oldest asset classes. There is nothing new or surprising about lending. What P2P lending platforms allow is for almost anyone to become a lender, benefiting from the returns that have historically only been available to institutions such as banks.

The P2P element is simply a process of connecting those who want to invest their money with others who want to borrow. Borrowers can range from individuals to companies. Octopus Choice, for example, allows people to invest in loans secured against property. Other platforms focus on areas such as business loans, and there are niches for investing in a whole number of different areas via P2P lending, from car finance to student loans.

Loans are facilitated through platforms that pool investors’ money, perform credit checks on borrowers and manage all aspects of the lending process.

How can P2P offer such high interest rates?

Most people will have already had their money lent out, in the form of savings deposits which provide the basis for bank loans and mortgages. Savers provide the capital for bank lending, but have no say in how their money is used, and see only a small slice of the returns.

P2P lending allows you to actually become the lender, typically alongside many other investors. That means you can cut out the bank, and directly access the beneficial interest rates of lending, which vary in accordance to the amount of risk you’re taking on.

What are the risks with P2P?

As with any investment, P2P lending comes with a degree of risk, as there is a possibility that a borrower might default on their loan. Investors also need to be aware that P2P lending is not covered by the Financial Services Compensation Scheme, so your loans are not insured in the way that deposits in a savings account would be.

Typically, you can assess the risk of a P2P loan against the target interest rate offered. The higher the estimated rate of return, the higher the risks are likely to be. As always, it pays to think hard about your risk appetite, and to hold a diverse portfolio that doesn’t over-expose you to any one investment.

Despite this, though, for many, P2P investing is a credible alternative to the traditional options of cash savings or equity investments. By offering relatively high interest rates, without exposing investors to the fluctuations of the stock market, P2P lending is becoming a mainstay of the alternative investing market.