With 99% of savings accounts paying less than the rate of inflation in September 2018, peer-to-peer (P2P) lending is becoming an increasingly popular way for people to make their money work for them — and without the need for big banks. In this article, Nicholas Harding, CEO of P2P lending platform Lending Works, explains exactly what P2P lending is and whether it is a safe way to invest your money.

What is peer-to-peer lending?

In its simplest form, P2P lending allows you to loan out your money directly to others at a set interest rate over a set period of time. This form of lending cuts out banks and allows people to loan each other money through the use of an online P2P platform.

Those looking for personal loans to fund a new car, home renovations, or a holiday can apply for a P2P loan after going through a strict credit-checking process. When you invest money into your P2P account, it will be lent out to approved individuals, who will then make repayments plus interest over time, providing you with a return on your investment.

Why invest in peer-to-peer lending?

With the Bank of England base rate still sitting below the 1% mark, more and more people are turning to P2P lending as an alternative form of investment, driven by the potential for much higher returns than savings accounts. P2P platforms have seen a surge in popularity over the last few years, largely down to the fact that they have much smaller overheads compared to traditional financial institutions.

It's a win-win situation: borrowers benefit by being able to access finance at a lower interest rate than would be available at many banks, while lenders are able to achieve better rates of return than other financial instruments such as savings accounts, ISAs, and possibly even some stock portfolios.

How does peer-to-peer lending work?

P2P platforms connect borrowers and lenders. On some P2P platforms you can assess potential borrowers on a loan-by-loan basis and decide whether you would like to risk your money by lending to them. On others, the platform will help you mitigate risk by lending out small amounts to a wide range of borrowers.

The beauty of these different systems is that a loan can be funded by a single investor or hundreds of them. Like a typical bank loan, the borrower will repay a portion of the loan each month plus interest over a pre-agreed lending period. You can also choose to either withdraw your investment income each month or reinvest it for compounded returns.

The risks of peer-to-peer lending

While it may seem like investing via a P2P platform is a no-brainer, it is important to realise that there are risks associated with doing so, as with any form of investment. The first thing to understand is that P2P loans are often unsecured, meaning there is nothing put up as collateral to back the loan should the borrower default on repayment.

Fortunately, the P2P market is now regulated by the Financial Conduct Authority (FCA) and there are minimum standards that platforms must meet in order to operate. Transparency and consumer protection are key, and platforms must now hold certain levels of capital in reserve to cover operating costs. P2P platforms must also put in place plans for the management of their total loan book, should the platform itself run into trouble.

Increasingly, P2P platforms are bringing in their own measures to raise consumer confidence in this burgeoning industry. Many now automatically diversify your investment across a range of loans, ensuring that any defaults are smoothed out across all investors, providing much more stability to lenders. Lending Works offers both a reserve fund and automatic diversification, as well as a unique form of insurance that protects against some of the most common reasons for borrower default such as loss of employment and illness.

While headline rates of return are attractive, you shouldn't rush into any financial decision — especially one in which your capital is at risk. A wise investor is one who takes the time to understand what they are investing in, whether that is a business, an individual, or a bank. No form of lending is completely risk-free, but the more time you take to understand what you are doing, the lower your potential risk will be.

As with all investing, P2P lending puts your money at risk and you may lose it should something go wrong. The best advice I can give you is to do your own research, find a P2P platform that resonates with you, and stage your investment over a few months as you expand your knowledge on the sector.