Lending money to strangers might not seem the most sound way of securing an investment return. But, with banks unwilling to lend or borrow, the peer-to-peer lending space is growing rapidly. These companies claim it is a win-win situation: borrowers get a low-cost loan, while lenders get a better rate on their savings. But what are the caveats?
The peer-to-peer finance market consists of companies that allow people to lend and borrow money directly with each other, setting their own interest rates. It also closes the gap between what savers earn and what creditworthy borrowers lend, drastically reducing the banks' traditional wide margin in the middle, as one peer-to-peer lender puts it: "There is still a middleman – but we are a much 'thinner' middleman."
One of the better known players in the market is Zopa, founded in 2005 by veterans from online bank Egg and previously discussed in the Investors Chronicle (see Lending money to strangers). A web-based service offering, Zopa matches retail lenders to retail borrowers. Borrowers are then rated according to their credit quality and are lent money either by one individual or, normally, a diversified pool of lenders. All money is lent in £10 packets – so a loan of £500 (a sensible minimum to achieve diversification across lots of borrowers) will be spread across 50 different borrowers to lower the impact of an individual borrower defaulting.
While the average annual percentage rate (APR, or the cost of borrowing for a year) for an unsecured consumer loan from a high street bank stands at 12.7 per cent, APRs on Zopa loans can be as low as 6.1 per cent. Unsurprisingly, Zopa loans are rapidly growing in popularity, with more than £185m now lent.
For income-hungry investors, Zopa's offering could be alluring and an alternative to cash or bonds. The average return enjoyed by Zopa lenders on loans made over the past 12 months has been 6.2 per cent a year (after fees but before any bad debt) - substantially more than the average return on cash. Zopa says the 6.2 per cent is an average - in reality individual lenders can be earning higher rates if they are prepared to wait longer for their offers to be taken up by borrowers.
The charge to lenders is 1 per cent per year on the money they have lent. If a lender wants to 'withdraw' money from his loans, they can do so through the Rapid Return feature (where your loans are taken up by other lenders). There is an additional 1 per cent charge for doing this.
While Zopa reports that the default rate on all lending since its launch remains below 1 per cent, borrowers are now facing a climate of rising unemployment which could lead to increased bad debts. While Zopa and other players in the peer-to-peer lending space try to reduce this risk by a cautious credit assessment of borrowers and asking the lender to diversify their risk via a portfolio of multiple loans, the risk of suffering default is always there.
Newcomer RateSetter, which entered the peer-to-peer market in late 2010, has sidestepped the issue of bad debt by introducing capital into the system. All borrowers contribute a proportion of their fees to the company's 'provision fund' which is currently around £420,000 and growing. If a borrower is late on a payment, or defaults on his loan, the provision fund steps in to compensate the lender.
While the provision fund is not a guarantee, it is managed with the intention of returning every penny of capital and interest to every lender, and so far has compensated 100 per cent of the claims made to it.
"By relying purely on diversification, other peer-to-peer models contain an element of 'luck'," says RateSetter founder and chief executive Rhydian Lewis. "Each saver must usually lend to 50 different borrowers. Some lenders will suffer no defaults, some will suffer multiple defaults. The provision fund mutualises the risk across all borrowers and creates a shield against the risk of bad debt."
RateSetter charges borrowers an arrangement fee of anywhere between £35 and £100, depending on the term of the loan. It also charges a credit rate fee, which is calculated as a percentage of the loan (0.5 per cent to 4.0 per cent depending on the borrower's credit profile), and this then goes into the provision fund, which is ringfenced from the business and held in a discretionary trust.
Lenders pay 10 per cent of the interest they earn to RateSetter. This is included in all the rates shown on their website - these rates are after fees and after provision for bad debt (a lot of providers state rates before fees and bad debt have been taken into account).
Of course defaults aren't the only risk with peer-to-peer lending. You will have to pay tax at your marginal rate on any earnings – it is also not possible to utilise peer-to-peer lending in an Isa.
Peer-to-peer finance companies are not deposit-taking institutions and therefore are not covered by the Financial Services Compensation Scheme (FSCS). But companies such as Zopa and RateSetter are currently regulated by the Office of Fair Trading under the Consumer Credit Act. The government has proposed moving the OFT's responsibilities to the new Financial Conduct Authority (FCA).
Three leading peer-to-peer companies – Zopa, RateSetter and business lender Funding Circle – have also set up an association to put minimum operating and capital standards in place: the P2P Finance Association. (www.p2pfinanceassociation.org.uk)
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