Finding decent returns on your cash is hard work in the current savings market, so it is little surprise that peer-to-peer (P2P) lending has become increasingly popular.

P2P is a means by which investors lend their money to borrowers through platforms so they can potentially get better returns than they would from a cash savings account, but it is certainly not without risk.

The Financial Conduct Authority has regulated P2P since 2014, and it is looking to bring it under the auspices of the Financial Services Compensation Scheme (FSCS). But as it stands, P2P is not covered by the FSCS so do not expect recompense if your money is lost, although you could potentially take a case against your adviser if you were not properly advised.

Is P2P something you should try?

P2P is very much part of the disruption of the traditional banking model; P2P enables people to bypass the banking system. As such, it is something which I think adds to the choices available to individual investors and could be a win-win formula.

However, it is not without risk and as a new investor, you should proceed cautiously. Here are some issues to consider.

Risk and reward

You can get rates of as much as 9% on some platforms although 3-4% is much more normal. Do remember the adage that the higher the interest you are receiving on your money, the greater the risk you are likely to be taking. So, at a very basic level, it’s worth remembering that it is very possible to lose your money if the borrower is unable to repay you. If that was to happen, then your only recourse is the platform.

Therefore, you should always find out what measures the platform has in place to protect your money from bad debts.

Credit checks

Borrowers should be stringently credit checked by platforms to reduce the risk of defaults, so find out which credit firm your chosen platform is using. Equifax, Experian, CallCredit, Graydon or Dun & Bradstreet are all UK credit bureaux and at least one of these should be used to filter both personal and commercial borrowers to further galvanise the process.

Innovative Finance ISA

Investing in P2P through an Innovative Finance ISA has been an option since April 2016, although companies have been slow to offer these.

This creates a third type of ISA alongside cash and stock and share ISAs, and makes P2P investing tax efficient. This ISA will be treated in the same way as any other ISA for inheritance tax purposes too.

Due the regulatory requirements and potential for things to go wrong, you may not find many advisers offering advice on these ISAs so if you are looking to invest in these, it may have to be a DIY job.

How secure is your money?

Borrowers of P2P money could be businesses or individuals, and how the loan is secured will be a major factor in how safe your investment is. Some secure loans take a first charge against a property, others may not be secured at all, so if a borrower fails to repay, you lose out.

Diversifying your risk is essential under these circumstances, and most platforms will automatically split your investment across several borrowers to reduce the risk of default. But you should also check other measures they have in place to deal with defaults.

The way in which the money is secured varies from platform to platform but in general platforms will have a ‘provision fund’ which is used to compensate lenders against bad debt. However, even if this is in place, check the platforms record for capital return and the size of the fund earmarked for compensation, how comprehensively it covers the platform’s credit risk and its track record of using its provision fund to repay investors’ capital.

So, should you invest in P2P?

If you are keen to start investing in P2P loans, then my advice would be to start small until you understand, and are comfortable with, the process. If you are a cautious investor, no more than 5% of your overall portfolio should be committed to this sector.

Use a well-established platform as many platforms have opened and closed. I would use ZOPA; this was one of the first platforms to be set up in 2005 and it has a good track record, deep experience of credit rating and a decent protection fund.

As with any type of investment, if you are unsure about whether P2P is relevant for you, then either seek advice from a professional or if you cannot get advice then take the time to learn about P2P – establish some parameters and take a gradual approach. As you may have heard, often there is no gain without pain but if you manage to go through the pain barrier, then the rewards could be well worth it.

Anna Sofat is managing director at Addidi Wealth