A new banking alternative is emerging into the mainstream as savers cast around for decent rates in an otherwise subdued market and borrowers dodge the squeeze.

Peer-to-peer websites cut out the middle man (i.e the bank) to match borrowers with lenders – in theory a win-win scenario for both sides because each have access to better rates than they might otherwise find.

But is peer-to-peer really the way to beat low savings rates, or is it too risky? We take a look at why both borrowers and savers are turning to the schemes that are halfway between saving and investing.

Peer-to-peer: Offering savers the opportunity to match their needs with borrowers is proving popular

The peer-to-peer story

The first peer-to-peer firm, Zopa, was launched in the UK in 2005, and along with the other two most established companies, Funding Circle and RateSetter, it has experienced huge interest from investors comfortable with a little risk.

Savers are enticed by returns of around 6 per cent, rather than the fixed-term savings market average of 1.22 per cent, or less.

The benefits for borrowers are that interest rates can be lower than those charged by traditional lenders and that there are no early repayment penalties.

This is particularly attractive to the self-employed and others who, because they have fluctuating earnings, may find it difficult to borrow from the banks and may also wish to repay loans early.

There have been some casualties along the way. A minor peer-to-peer firm Quakle, for example, went bust in 2011 leaving savers wondering whether they would get their cash back. The firm assured them they would and that it was ring-fenced, but this highlighted points of contention for early prospective investors.

For example, u nlike with a savings account you do not benefit from the Financial Services Compensation Scheme savings deposit protection of up to £75,000, if someone defaults on your loan then you take the hit - although some platforms developed fallback funds, which compensate savers for bad debts. [Though under new rules, poor advice given about peer-to-peer investment is now covered by the FSCS.]

Extra risk over saving did not put people off, with peer-to-peer proving something of a goldmine. Figures released for the first quarter of 2016 by trade body the Peer 2 Peer Finance Association showed that borrowers and investors looking for a better deal had poured £5.1bn into the industry since it started compiling the data in 2010.

This surge in interest was also supported by the introduction of industry-wide regulation in 2014, which has served to further establish peer-to-peer into the mainstream.

Cutting out banks: peer-to-peer platforms match borrowers with lenders directly

Regulation

Peer-to-peer has come a long way from its lowly beginnings as a little-known alternative investing option.

An independent benchmarking survey of UK Alternative Finance found that peer-to-peer consumer and business lending platforms are now the largest form of modern finance in the UK.

Initially the industry was not FCA regulated, which meant there was no official safety net making sure your money is protected if a firm goes bust.

To tackle this, the Big Three, Zopa, Funding Circle and RateSetter, established their own risk models and a seemingly robust industry association with tough rules on joining. They also apply tough criteria to who they will lend to.

But in 2014 new regulation was brought in to protect investors. This is a sign that the sector has become more established as a financial option in its own right. It is still very small comparatively, but growing fast.

Now peer-to-peer platforms must have strict systems in place, which are overseen by the FCA.

Under the rule change, peer-to-peer, also known as lend-to-save, is classified as loan-based crowdfunding, but the FCA seems happy enough to let the industry carry on calling itself peer-to-peer.

And as of April 2016, FSCS may be able to compensate eligible investors in relation to unsuitable advice they receive about the merits of investing in peer-to-peer lending via loan-based crowdfunding platforms.

Depending on individual circumstances, FSCS may be able to provide compensation of up to £50,000 in relation to investment advice given on or after 6 April 2016.

NOT SAVING OR INVESTING - MORE LIKE A CROSS BETWEEN THE TWO Because peer-to-peer firms are outside the remit of the Financial Services Compensation Scheme (see below) for all but advice , lending your money via these online companies can't really be described as 'saving', because there is an element of risk. As such, in theory the concept is more like investing, as you are risking money. The return on your investment is entirely dependent on the solvency of the people it is being lent to, although individual firms - and now the sector as a whole thanks to regulation - have their own ways of trying to minimise the pain of defaults. U ltimately, lend-to-save is a cross between saving and investing. You must accept that there is a potential that you will lose money but the firms are replicating the basic principle of saving - with safety nets in place. Those who opt to put money in must weigh up whether the extra reward over a savings account merits the extra risk and should remember to never put all your eggs in one basket.

How do the rules affect you?

The new systems have been designed to ensure your investments are ring-fenced from the company's finances, so if anything were to go wrong with the platform your cash would be protected.

Firms must also have a third party treasury in place, ready to take over if the worst should happen and the platform goes under. This must be a seamless process so that the investor or borrower is not inconvenienced in any way by a takeover.

In these circumstances, the idea is that loans continue to operate until the end of their term - although new loans may or may not be taken on, depending on the circumstance.

Regulation also means that all investors and borrowers have a 14-day cooling off period in case of a change of heart - if the platform does not have a secondary market to sell off loans - as well as access to the financial services ombudsman, for any complaints.

The new regime also takes a robust view on disclosure. This means the pros and cons of any investment must be made 100 per cent clear.

More specifically, peer-to-peer platforms are not able to sell their services as 'risk free'.

Unlike savings or bank accounts, neither loan or investment-based crowdfunding is covered by the £75,000 Financial Services Compensation Scheme [for anything other than advice given since 6 April 2016], so don't be lulled into a false sense of security by regulation - despite their similarities, loan-based crowdfunding is still very much an investment, rather than savings product.

Finally, platforms must have capital reserves ringfenced, too. Zopa and RateSetter already had fallback funds of this kind. These cushion investors from any defaults, although theoretically if every person defaulted at the same time they probably won't be large enough to cover the entire loans book.

Commission and fees

Although headline rates are a huge draw, borrowers and lenders will need to look out for charges and fees.

Despite these costs, peer-to-peer still offers better rates than are often available through mainstream savings and borrowing markets. Each company charges different amounts, but all depend on the amount you lend or borrow, and how long for.

Tax-free returns

A new 'innovative finance Isa' has been created, allowing peer-to-peer investing to be held inside the wrapper.

P2P lending via firms such as Funding Circle, Rate Setter and Zopa, allows savers to 'lend' money to individuals or businesses, cutting out the middle man of the bank or building society and, as a result, typically earn higher returns.

For 2016/17, the tax-free allowance for innovative finance, cash and stocks and shares Isas is £15,240. Savers can choose to mix-and-match between the three. While The Big Three have announced their new Isa products and the rates they will pay, regulator delay means they are not yet able to accept money just yet and could be kept waiting until the autumn. Some newer, smaller, providers are though. The table below shows the providers already accepting Isa money.

PROVIDERS ALREADY OFFERING THE INNOVATIVE FINANCE ISA Lender Rate Abundance Up to 9% (funds won't be invested until October 2016) Crowd2Fund Average of 8.7% Crowdstacker Up to 6.8% Source: Money.co.uk

And here's a look at what the other players intend to offer later this year:

PEER-TO-PEER PROVIDERS AWAITING APPROVAL Lender Rate ThinCats Average 9% Funding Circle Estimated 7.3% Zopa Easy access 3.5%, Zopa Classic 4.5%, Zopa Plus 6.5% RateSetter Will fluctuate depending on demand but 5-year rate at 30 March 2016 is 6.1%

HOW DO THE BIG THREE COMPARE?

Zopa was the first online lend-to-save firm anywhere in the world when it launched in the UK in 2005, setting a benchmark for others to follow.

Now 11 years old, it has arranged more than £1bn in loans.

Each month, lenders receive repayments from their borrowers, made up of the interest they are owed and a small portion of the outstanding capital. These payments can be immediately reinvested as new loans or left in the customer’s account to be lent in future, or withdrawn.

If a borrower does fall behind with their repayments for any reason, Zopa employs a collections agency to chase them - just like a bank might.

RateSetter was the first lend-to-save platform to introduce a ring-fenced fallback pot, its Provision Fund.

Borrowers on RateSetter contribute to this £17.8m fund, which is called on in the event of a missed payment or default. RateSetter boasts the largest coverage ratio of provisional funds to bad debt.

It is not a guarantee, but is managed on behalf of all lenders and met every claim that has been asked of it.

This means that every lender on RateSetter has received every penny of capital and interest expected - the only lend-to-save firm that can claim such a feat.

The fund is a separate entity, ringfenced from RateSetter’s business, and managed on behalf of all lenders.

Bad debt is worked out by defaults they've had divided by the total amount that they've lent.

RateSetter also allows lenders to adjust the rate you wish to lend money at. The higher you set the rate, the longer it will take the order to get matched and for the money to be lent out.

Money is matched usually within 24 hours if set at the current rate. If you set a lower rate you will get matched faster, set a higher rate and you will get matched slower.

Funding Circle was established in August 2010 and enables investors to lend cash direct to small businesses.

It only deals with creditworthy SMEs in the UK, many of whom have been left out to dry by the banks.

Loans are funded either by one large investor or many investors offering small amounts.

Funding Circle's Autobid tool automatically places bids according to the criteria investors have set. Investors can choose the average rate they wish to offer, which types of businesses they want to lend to, and the maximum percentage of their portfolio to be lent to any one business.

Secured vs unsecured lending The Big Three - Zopa, RateSetter and Zopa - are examples of unsecured peer-to-peer loans. The investor's money is not secured against an asset, such as a car or property. However, some platforms do offer secured peer-to-peer loans. These include LendInvest and Wellesley, which allow property professionals to borrow money secured against the properties they own.

However, because Funding Circle deals with businesses, the default rate is slightly higher.

In the unlikely event that Funding Circle ceases trading, an S&P rated loans servicer would step in and continue to collect repayments from borrowers, and distribute these to lenders.

Do you want to find out about investing in small businesses? Click here for more on Funding Circle

PEER-TO-PEER PLATFORMS COMPARED Unsecured lending Secured lending Zopa RateSetter Funding Circle LendInvest Wellesley Information for investors



Cash loaned to Individuals Individuals, UK SMEs and property developers. Small businesses Property companies, developers and investors Property companies, developers and investors Minimum lend £10 £10 £20 £100 £10 Length of term Up to five years Monthly or up to five years Up to five years Up to 1 year Up to three years Easy access? Yes, usually within days Yes, usually within days (see fees section below) Yes No Yes, subject to loss of interest Rates Estimates vary by product type from 3.5% to 6.5%. Actual current annual investor return is 4.8 per cent (after defaults, before tax and assuming re-lending). Lenders set their own rates but the market annualised rates in mid-May were: 2.9% rolling market (where money is loaned in terms varying from 6 months to 5 years); 3.85% 1-year, 4.9% 3-year, 6% 5-year. Current estimated annual return: 7.3% after fees and bad debts. Fixed net returns from 5% (annualised) Up to 3.75% (paid on maturity after three years) Fees No lending fees. 1 per cent charge on loans sold on to others. Early access fees apply. 0.72% average sell out fee for 1, 3 and 5-year markets. No fees for withdrawing from rolling market. 1 per cent annual fee, 0.25 per cent sale fee



Information for borrowers



Rates Vary depending on credit rating. Average in mid May was 7.9 per cent 7.2% representative APR. Starting from 6%

Extra fees? Origination fee included in APR Administration fee and credit rate fee included in APR Completion fee included in APR Early repayment fee? No No No



Min/max loan £1,000 to £25,000 £1,000 to £25,000 £5,000 to £1m

Length of term Up to five years Up to five years Up to five years

SPREADING YOUR RISK As part of investing via peer-to-peer, it’s important to remember that a percentage of borrowers, or businesses, will be unable to repay their loan. Funding Circle allows you to cut your loan into smaller chunks so that your risk is diversified - you can lend as little as £20 per business. It also allows you to buy parts of existing loans from other investors, allowing you to diversify your portfolio even further. This is an added benefit for those who want to access their money quickly, although you must pay a 0.25 per cent fee to sell off part of your loan. Funding circle also grades each business on its risk level to make it easy to compare high and low risk. Returns are directly linked to this risk. Zopa, too, diversifies your risk by spreading loans among borrowers, and rating each on risk. So, if one borrower doesn't stump up, the hit on your stash isn't catastrophic – it should just bump down your rate a bit. You can bolster this yourself by lending in different markets (they grade borrowers by credit score), or using multiple peer-to-peer sites. RateSetter, on the other hand, does not split your loans across multiple borrowers. Its provision fund is there to mitigate the risk of individual Borrowers defaulting – if a borrower fails to pay, then the provision fund steps in to compensate the saver. Remember that ultimately whatever provisions put in place by providers, this does not carry the official protection of a savings account and you need to weigh up whether the extra return you are getting is worth the extra risk you must take.







