by George Hatjoullis
There has been a huge growth in P2P lending in the last few years. The motivation pushed by the P2P lenders was to cut-out the ‘fat cat’ banks. Looking at the fees charged, to both lenders and borrowers, these online providers are not exactly undernourished. Not all providers are equal however and it is unclear that all those indignant savers that have rushed to lend/borrower through these providers grasp the issue. Why?
Lenders loan money to a range of borrowers and have a loan portfolio. Some borrowers will default and the FSCS does not cover losses in this case. This is reflected in the interest rates charged and there is always an estimate of the interest rate after likely losses. Unfortunately, this is misleading as the true interest depends upon your personal tax position in the UK. If you incur losses you cannot offset the principal loss on one loan against interest earned on other loans. If you incur losses on your portfolio you are liable for income tax on the gross interest earned on your portfolio. If you earn £100 after fees but you incur losses of £40 you will still have to declare the £100 as income. If you are a 20% marginal taxpayer this means your net return after fees, tax and losses is only £40. You pay £20 to the tax man leaving £80. You have lost £40 owing to defaults leaving £ 40. If you are a 40% taxpayer then you are left with only £20.
Some P2P lenders offer collective loan funds and manage the loan loss risk for the lender. This is reflected in much lower offered interest rates. The interest charged to the borrower (and the fees) remains the same. Also the fee charge to the lender remains the same. What happens is that the P2P provider establishes a contingency reserve and makes good principal losses from default to borrowers. It funds the reserve by keeping back the extra interest charged to the borrower. Of course, if the P2P provider miscalculates the reserve may not have enough to meet loan losses and lenders could still lose money. However, with a pooled fund and professional manager this should be a rare event.
The headline interest rates offered to lenders are commensurately lower when the contingency reserve applies. However, if tax effects are allowed for the difference is small and especially for higher rate taxpayers. In fact if loan losses are typical this approach may improve the yield over time.
Providers that do not offer lending via a pooled contingency fund are offering a fundamentally different product. The lender must construct her/his own loan portfolio and take the loan loss risk and consequent tax implications. Given the lack of experience of most lenders, and lack of skill in managing a credit portfolio, it is surprising that so many take this option. Only a zero rate tax payer might claim to be indifferent between the two type of products but would a zero rate tax payer be an experienced credit trader? Lending via a contingency fund is the only sensible option for the average taxpayer.
I have loaned funds via four P2P providers. My experience is that lending to small businesses is very risky and that even guaranteed loans can default and the process of recovery is tortuous at best. I am running my portfolio down with this provider. My after tax return is disappointing. It does not offer a contingency fund and this may not be unrelated to the risk of lending to small businesses. Lending to individuals has been more gratifying. Loan losses have been slight and well within predicted parameters. The return has been very good. Interestingly my provider no longer allows new loans directly to individuals and now requires new lending via a contingency fund. I have also loaned money via an original contingency fund and the result has been exactly what I expected. The original rates were lower but the net after tax return has been good. Other contingency funds are now available but not all offer the same interest rates net of fees. There are material differences in net interest rates. It is unclear why this is the case and why more lenders do not gravitate towards to the higher rates. It may, of course, be that the quality of the loan book and contingency reserve differs across providers. However, there is insufficient information available to make this determination and most investors would struggle even if they had the information. I shall be investing some in all my providers for a while if only to track how performance evolves.