Peer to peer lending is a model of debt-based crowdfunding which takes place through online platforms. These platforms match lenders (often referred to as investors in a P2P finance context) looking to grow their wealth via offering loans with individuals or companies looking to borrow funds. This model cuts out the bank, or the intermediary, with the intention of reducing the cost for both parties.
Lenders can often get much higher rates than they would from a savings account, while borrowers pay less interest than they would with a conventional loan. P2P lending can be used for all types of loans, in this post we focus on small business loans.
When P2P lending first came about, it was a lending system designed to offer access to credit for people and businesses rejected by conventional finance institutions. However, as P2P lending platforms have grown in popularity P2P loans are more and more being taken out by businesses and individuals just looking more favourable rates as opposed to traditional loan finance.
P2P Lending Process
Many peer to peer loans are classed as unsecured personal loans, which means there’s no security or collateral needed to take out the loan (in many cases even loans for business purposes).
As such, it’s one of the more accessible forms of funding, and one of the lower-risk finance options for borrowers. The process of P2P lending is different for lenders and borrowers, each group/process is detailed further below.
From a Borrower Perspective
The P2P finance process from a borrower perspective largely follows the below steps:
- Complete and submit an application form, usually done online. As part of this process, the lending company typically carries out a credit check.
- Based on the information you provide, the lending platform assigns you a risk category or grade. This rating determines the interest rates and terms that you will be offered. If you’re happy with an offer, you can choose to proceed.
- Investors then review your loan request, including how you plan to spend the money and why you don’t pose a high risk. On some sites, lenders may bid to try and win your business.
- If an investor offers you a loan, you then have the option to review and accept it.
- Once you’ve accepted the loan, the funds tend to appear in your account within a few hours or days.
- You then make monthly payments to repay your loan. Generally, P2P lenders report accounts in the same way as traditional lenders, meaning that late repayment could harm your credit score. Some platforms may also charge fees for late payment, which are to watch out for.
From a Lender Perspective
Lenders (Investors) are people looking to grow their wealth by lending with the aim of seeing a return on their money. The process from a lending perspective typically follows the same as the below:
- First of all, an investor opens an account with the relevant peer to peer lending website and deposits a sum of money that they want to loan out.
- The lending party can set interest rates. On some sites, lenders will compete with one another to offer the lowest rate. On other sites, the peer to peer lending company will set a fixed rate based on the borrower’s credit rating and history. Lenders must decide how much they wish to lend and for how long. Typical loan terms are between one and five years.
- Loan applicants post a financial profile on the same sites, detailing the amount they wish to borrow. Each loan applicant is assigned a risk category, determining the interest rate they will have to pay to borrow funds.
- Loan providers can view the profiles and choose the applicants they want to offer a loan to, or set automated parameters that enable the site to do it for you.
- The lending companies, or the P2P lending platforms, make money typically by collecting a one-time fee on loans from borrowers and, in some cases, charging a fee to investors to use the service.
Types of Peer-to-Peer Lending
Business
P2P business lending is becoming more and more popular as a source of finance for companies looking to fund growth, purchase materials, assets or stock or to bridge cash flow issues. Business lending tends to be secured against property, via other business assets or by a personal guarantee from the directors.
Consumer
The most traditional form of peer to peer lending is consumer lending, which is how P2P started in the first place. It involves lending money to an individual, for whatever reason they need it. Nowadays, platforms tend to hide the reasons that individuals are seeking funding, but it works the same way. These type of personal loans are often unsecured, which makes it a bigger risk for the lender, as there’s little chance of recovering the money if the borrower defaults – however this typically allows investors to set higher interest rates to offset potential risk (this requires an investor to have made multiple loans though).
Property
Lending against property is less common for P2P and typically used for short-term development projects, such as extensions or refurbishment. Property lending is also risky, as the project could always go wrong.
For the investor however, it carries fewer risks than unsecured P2P lending, as the loan is usually made on condition that the property can be sold to recover the monies owed in a worst-case scenario.
P2P Lending – Tax Treatment
How is P2P interest taxed?
For tax purposes, HMRC views most money earned through peer to peer lending as income, which is taxable. For most lenders, they won’t pay any tax due to the personal savings allowance, which allows basic rate (20% in 2020) taxpayers to earn up to £1,000 of tax-free interest.
Higher rate taxpayers (40% in 2020) have access to the same scheme but have a lower tax-free limit of £500. Any interest earned above these thresholds is liable to tax, which you must pay at your highest marginal rate of tax. Additional rate taxpayers are not eligible for a personal savings allowance, so anybody who earns more than £150,000 per year must pay tax on all their savings.
As a lender can I hold my P2P loans in an ISA?
Investors can now choose to have their P2P loans held in ISA, thanks to a new type of ISA called the Innovative Finance ISA (IFISA), introduced on 6 April 2016 especially for peer to peer lending. ISAs are Individual Savings Accounts which allow the holder to save, tax-free.
This is an attractive option for investors, encouraging them to put their savings in peer to peer lending sites and watch their money grow. Often with the IFISA, you can receive interest from your loaned funds through P2P without paying tax up to the annual limit of £20,000 (2020).
Final Thoughts and FAQs
Often hailed as one of the most innovative forms of investing and borrowing to come out of the last twenty years, P2P lending has seen a steep rise in popularity in the last decade that shows no signs of slowing down. By circumventing the conventional loan requirements and traditional funding routes, this form of finance offers competitive rates for lenders and borrowers alike.
As with any form of investment, P2P lending comes with significant risks. It’s never a guaranteed form of savings, and you never know when your P2P lender could go bust. That said, the market offers impressive growth rates and is a fantastic way for start ups to source their initial seed funding. For individuals, it’s also a more accessible way of getting credit, bypassing traditional admin-heavy routes. It is therefore worth considering next time you’re looking for quick access to a loan or an easy way to grow your funds.
