Low interest rates may be great for borrowers, but savers and investors have been in the doldrums for years. Frustration might drive you to look at alternative investments, with a popular one today being peer-to-peer (or crowd) lending. But how does this work – and is it worth the risk?

For a long time, savers have had the thin end of the wedge. The very best instant access savings accounts deliver barely more than 1.5 per cent, while even locking in your money for five years will bring in only around 3 per cent at best. But maybe you’ve already heard talk of another way to earn interest, with instant-access rates of over 3 per cent and longer-term returns of more than 6 per cent. Too good to be true? Let’s take a look.

How does it work?

Peer-to-peer lending (sometimes known as crowd lending) has surged in popularity over recent years, due to a combination of demand – people desperate for better interest rates – and the online technology to make it work. There’s nothing new in the concept itself; savers have always earned interest by depositing money in banks, which then lend it out to other people, so that the saver receives some of the interest earned on the loan. The difference is that in this case, there is no bank. Peer-to-peer lending aims to cut out the middleman, leaving more of the interest for the saver.

Why ‘aims to’? Because of course, there is still a middleman, which is the provider firm (the big ones currently are Zopa, Ratesetter and Funding Circle). But because these are essentially web-based platforms with fewer overheads than a bank, they can pay a higher rate of interest to savers. They may also be able to offer slightly lower rates to borrowers too.

What’s the catch?

Of course there is a downside: although peer-to-peer firms are now regulated by the FCA (since April 2014), unlike savings they are not guaranteed by the government. If your bank goes under, your savings are guaranteed up to £85,000 (falling to £75,000 from 2016). If your peer-to-peer firm fails, or if too many borrowers default on their debts, you could lose your money.

You also need to realise that the returns, though attractive, are not guaranteed, and nor is your capital sum. If too many borrowers do not repay their loans on time, there may be no money to repay the lenders (i.e. you, the saver). The new regulation requires peer-to-peer firms to keep at least £50,000 of capital by April 2017 to cover bad debts, but this isn’t really very much.  Larger firms are required to have larger safety funds – Zopa’s runs into millions – but this still can’t compare to the savings guarantee, which covers every single individual with money in a bank.

Another thing to be aware of is that you might not start earning that promised rate of interest straight away. It depends on how soon your cash can be lent out – in the meantime, it may just sit in a bank account. This is more likely to happen if you invest a large sum at once.

Proceed with caution

The burning question remains: is peer-to-peer lending right for you? And would a financial adviser recommend it? To date, most advisers have been steering clear of suggesting this kind of venture to their clients, but this may well change in the near future as the practice enters the mainstream. In any event, an adviser would only recommend it on a case-by-case basis, as part of a balanced investment strategy that takes all your circumstances into account.

The usual rule about investments applies here too: greater returns mean greater risk. You need to weigh the prospect of earning higher interest against your ability to take that risk on. Or in other words: don’t invest more than you can afford to lose.

Here’s an example. Sally is relatively seasoned investor, with a portfolio consisting of equities (high risk but potentially high returns), bonds (lower risk but steadier returns) and cash (very safe) in roughly equal amounts. Sally estimates that peer-to-peer lending falls roughly between bonds and equities in terms of risk versus reward. So, as an experiment, she sells equal amounts of bonds and equities and invests this money with a peer-to-peer firm, so that this lending makes up a ten per cent slice of her overall portfolio. She monitors this investment’s performance carefully, and as she accrues interest she moves this extra money into her cash savings. Why does she do this? She does it to ensure that the peer-to-peer slice never makes up more than ten per cent of her overall portfolio, because that is the highest level of risk she’s prepared to take at the moment. She may vary this proportion later, depending on the success of her experiment.

The view ahead

Peer-to-peer lending may be one of those ideas whose time has come – the appetite is there, as is the technology. Providers are trying to woo and reassure investors by offering platforms that closely resemble savings accounts, with fixed rates of interest and more protection against risk – but this may in the long term undermine their advantage. Having tried to reinvent the bank, peer-to-peer firms could end up evolving into banks themselves – a lot safer, but also less exciting.

As things stand, though, they remain higher-risk options for the more confident investor, perhaps worth considering but only as one component of a broad and balanced portfolio. Talk to a financial adviser about whether peer-to-peer lending could form part of your investments.

You can also book a free investments check with an independent adviser today to see if your portfolio could be improved.