Last year was a record year for peer-to-peer (P2P) with investors lending more than £3bn, and total lending reaching £7.2bn across 35 lenders, according to data from online lending ratings and research agency, 4thWay.

With rates on offer from P2P lenders ranging from 3%-7% depending on how long you invest your money for, and with some promising as much as 12%, it’s easy to see why P2P is gaining popularity. In comparison, the average easy access savings account pays just 0.39%, according to Moneyfacts, while a one-year fixed rate bond pays an average of just 0.89%, according to Savings Champion.

How does P2P lending work?

P2P lending works by matching individual borrowers or companies with savers who are willing to part with their money in the hope of getting higher rates of interest than they would receive from mainstream savings products.

The borrower/saver ‘matching’ process takes place on a P2P platform. RateSetter, Zopa and Funding Circle are just a few of the big names.

What are the risks of P2P?

The industry has also received criticism from the likes of Lord Adair Turner, the former chair of the Financial Services Authority, who said it would “make the bankers look like lending geniuses” and Andrew Tyrie, the chairman of the Treasury Committee.

P2P loans are considered more risky as they are not straight cash savings products, but more likened to investments.

The other major downside is P2P lenders are not protected by the Financial Services Compensation Scheme (FSCS) so if anything goes wrong and you lose your money, the government won’t help you.

Five top tips to make the most of P2P

Despite the risks, P2P lenders often operate their own safety net or provision fund which is used to absorb any late payments or defaults to ensure customers aren’t affected. If you’re considering P2P lending, here are five top tips:

1) Check bad debt of a P2P lender

Bad debt is a loose term that could mean loans that have missed several loan payments, where loans have been referred to debt collections team, or where some part of the loan has already been written off. It can also mean loans that have been extended due to the borrower having trouble making payments. It doesn’t usually include loans that are just suffering a late payment.

Neil Faulkner, managing director of 4thWay says a P2P lender should make it easy to find all its bad-debt figures on its website: “If you can’t find them, don’t invest. Move on to another P2P lender. As a very rough rule, for lower risk lending, you might want to see that the interest you earn is over three times the average annual bad debt. Alternatively, if loans usually last several years, the interest is roughly half the lifetime bad debt,” Faulkner says.

2) Checks to make when matching/lending your money

When deciding where to lend, the very least you can do, according to 4thWay, is:

• Glance at the About Us section and make sure you see a lot of relevant banking, “underwriting” and “credit risk” or “risk” experience.
• Make sure the P2P lender is focused on either very high quality borrowers or very good property security, or both.
• Make sure you’re getting a decent premium over the best savings accounts and cash ISAs.
• Check how easy it is to lend your money. Some P2P lenders give you simple options that allow you to easily and automatically re-lend any interest or loan repayments, and to spread your money across lots of loans. Others require you to sign in fairly regularly to choose loans for yourself.
• Consider any nice extras, such as reserve funds to pay expected losses, whether the P2P lender will cover the first loss out of its own pocket, or if there is insurance to pay lenders if borrowers are unable to repay due to accident or unemployment.

3) Diversify your money

Spreading your money across several platforms and hundreds of loans is the simplest and best way to dramatically lower the risk of losing money, says Faulkner.

“It’s not that unusual for stock-market investors to lose 25% on their investments even if they own 100 shares – before they quit the market in shock and disgust. In contrast, if you spread your money evenly between 100 lower-risk P2P loans, 4thWay’s median estimate is that your risk of losing 25% or more during a recession as horrible as 2008, or a smidgen worse, is under 0.1%. During normal years, based on actual historical loss rates, you have a greater chance of winning the National Lottery two weeks in a row than of losing 25% or more of your money.”

4) Review your holdings

4thWay says you should review your holdings at least once a year by checking out how bad debts have changed, whether more loans are running late, whether the platform still seems to be going strong, whether it is hiring more skilled people or shedding people, and whether it is still being completely open about its results and what it is up to. The firm has an alerts service for its subscribers let them know of major changes and to show when it is opportune to buy, hold or sell.

5) Consider IFISA for tax-free growth

If you have more than £10,000 in savings, or you’re a higher-rate or additional-rate taxpayer, your tax-free savings allowance might not cover the interest you earn through savings and P2P lending.

IFISAs are a new tax-efficient way to do P2P lending that covers the difference. You pay no taxes when you lend through an IFISA. You can open one IFISA per year and can currently lend up to £15,240 of new money this tax year. You can still open one cash ISA and one stocks and shares ISA.

Faulkner says you can transfer cash into an IFISA from cash ISAs, or from other IFISAs and from shares ISAs but when transferring from the latter two, you have to sell your investments and loans first before transferring the cash.

“Currently, just Abundance, CrowdStacker and Crowd2Fund offer IFISAs, with Lending Works’ due in January. I expect over a dozen more by the end of 2017,” he says.