By cutting out the middleman, peer-to-peer lending can offer higher rewards – our financial columnist shows you how to navigate the risks.

Our post-2008 world of near-zero interest rates has spawned many unusual financial phenomena. We now have cryptocurrencies and government bonds that offer negative yields – in other words, you pay for the privilege of lending the government money. That’s before we come to banks printing money, in the form of quantitative easing.

Compared with these innovations, the peer-to-peer lending industry looks positively sensible. The basic idea behind peer-to-peer (P2P for short) is to provide a platform through which people and institutions with savings can lend them to people and companies that need to borrow money. By cutting out the middleman – typically a bank – savers can enjoy better returns, and borrowers cheaper loans.

P2P lending was a fledgling industry prior to the financial crash, but low rates on savings accounts, a sense of societal revulsion towards the banks and the promise of attractive returns have seen the sector grow and diversify in the past decade. In the early days, P2P involved the likes of sector pioneer Zopa establishing a platform that simply matched individual lenders with individual savers, almost like Ebay for loans.

These days, the established operators offer Individual Savings Accounts (ISAs) that split your loans across different borrowers, while in the more niche areas you can find P2P lenders specialising in everything from lending and buy-to-let landlords to providing working capital through invoice financing (whereby the lender buys an invoice at a discount, helping small businesses to manage cashflow and credit risk).

Across the sector, promised returns vary, from as little as 3-4 per cent a year for simple consumer loans, to more than 10 per cent for risky corporate loans. Compared with a savings account paying out 1 per cent or less, that seems high. But that’s because, while P2P lenders are often cited as alternatives to the banks, these are not savings accounts. If the loans you make are not repaid, you won’t make those promised returns – you might even lose money.

That said, in the short history of P2P, many providers have delivered solid returns and satisfied customers. So the question is not so much, “Are the returns too good to be true?” as, “What is the nature of the risk I am taking, and are the potential returns high enough to justify this risk?”

DIVIDE AND CONQUER

The most obvious risk is credit risk. Even a solid borrower with the best intentions can run into unexpected trouble, so it’s important to diversify – divide your money across many different loans (we’re talking hundreds ideally). More established sites such as Zopa or Funding Circle will offer this automatically, but this won’t always be the case for smaller or more specialist platforms.

You should also diversify across platforms – if one goes bust (as Lendy did earlier this year), it shouldn’t affect whether you get your money or not (the contract is between you and the other party, not the platform), but it could delay getting it back.

How do you measure credit risk? One of the simplest and most obvious indicators is the return on offer. The higher the return promised, the more risk – after all, if someone has to borrow money at 12 per cent a year, it means they’re a) desperate for it and b) can’t get credit from anyone else.

That’s not to say high returns aren’t possible – for example, invoice factoring is a specialist area where institutional lenders and some high net-worth individuals have the expertise and confidence to analyse the companies involved. But lenders have been known to bite off more than they can chew. Swedish payday lender Trustbuddy imploded in 2015 partly because of the challenges of operating in the subprime consumer loan sector.

As a rule of thumb, once returns are getting much above 5 per cent, be very clear as to where the extra reward is coming from. Promises of double-digit income – particularly from new players – are best taken with a pinch of salt, unless you have a strong understanding of the sector in question.

Useful sources of information include 4thway.co.uk and altfi.com. Ultimately, treat P2P as you would any other investment. Don’t just look at the headline number – investigate what’s going on under the bonnet. If you can’t wrap your head around the risks, or where the returns are coming from – and can’t commit to tying your money up for the terms required – then give it a wide berth.

John Stepek is executive editor of Moneyweek magazine