Interest 1.0 – You earn interest from Banks
Interest is a fee paid by a borrower of assets to the owner of the assets as a form of compensation for the use of the assets.
For hundreds of years what most of us have understood interest to be, is the income we earn from depositing our money (assets) in the bank. But in reality we have been lending our money (assets) to the bank (the borrower) and in turn they have been lending that money to other borrowers (individuals and SME’s). The individuals and SME’s who borrow money from the banks, pay a higher rate of interest to the banks than the banks pay us when they borrow our money.
One of the many effects of the 2007 – 2008 financial crisis which has hit pretty much all of us is interest rates. The average Bank of England base rate from 1975 to 2008 was 8.5% pa and since 2008 it has plummeted by 95% to 0.5% pa and this has had a catastrophic effect on the level of income that we can earn by lending our money to the bank. The banks have in line with BOE base rates slashed the level of interest that they pay us. A second effect of the financial crisis is that banks have pretty much stopped lending money to both individuals and SME’s.
So the outcome is that I have money in the bank that I am earning minimal interest on and there are lots of people out there who want to borrow money and pay interest but the banks won’t lend to them.
Interest 2.0 – You earn interest from Borrowers
Nothing really new here, borrowers have always paid interest. The difference now is rather than the borrower paying interest to the banks they will pay interest directly to you, effectively cutting out the middleman – the bank.
Peer to Peer (P2P) companies bring together borrowers and lenders via an online lending platform, think of it as an eBay for money. Rather than selling assets as you would on eBay, you are lending assets (money) via the P2P platform and are paid compensation (interest) for doing so by the borrower. Depending on the platform, borrowers are offering to pay interest of between 5-15% pa. You won’t get that at the banks!
Platforms source lending opportunities (borrowers) who list their borrowing requirements, how much they are willing to pay in interest and whether they are prepared to support the loan by offering collateral or not.
The platform handles all the administration, funding process, documentation and then delivers the money from the lenders to the borrower. It then on an ongoing basis collects the interest payments from the borrower as they fall due and pays them to the lenders.
What is really clever is that rather than lenders and borrowers lending on a one to one basis, many lenders each lend a small part of a borrowers overall loan requirement. So a single borrower could have up to a 1,000 lenders who all lent a small part of his loan but he doesn’t care as long as his borrowing requirement is met. Technology allows the multiple lenders to be handled in an efficient and transparent manner.
It should be highlighted that although P2P platforms are authorised and regulated by the Financial Conduct Authority (FCA), they are not banks offering savings accounts and lenders making P2P loans are not covered by the Financial Services Compensation Scheme. Lenders capital is at risk, some platforms offer a provision fund to cover bad debts and some support the loans with collateral which can be sold if the borrower defaults.
The Peer to Peer or Direct Lending industry is still in its infancy but it has the potential to cause the biggest disruption to the financial and banking industry in the past two hundred years. Perhaps we need to get used to earning interest from borrowers and not from banks.