Can savers get better returns through lending?

Peer-to-peer lending cuts out the middleman, allowing investors to lend directly to real people, setting the time and interest rate for repayment. Many of the lenders are unsatisfied savers, who can get better returns by lending.

But higher interest rates come with a risk: the lending websites are not yet regulated by the Financial Services Authority and there's no money-back guarantee.

Zopa (short for 'zone of possible agreement') was the first peer-to-peer lender on the scene. Since it was set up in 2005, £100 million has been lent in the UK. Around 30 similar companies have since sprung up globally.

A growing market?

In June, YES-Secure launched, with an almost identical model but focussing more on the social side of lending. Both sites work similarly. Borrowers are credit checked through the sites' own criteria and then again by credit expert Experian.

Scored depending on their rating, A* members are the safest, with interest rates lowest for borrowers in this category.

There is no minimum loan amount and when one is offered, it is split between multiple borrowers to diversify the potential risk of payment default. However, borrowers can repay loans early, thus reducing the amount of interest lenders stand to receive.

At Zopa, loans are set at a fixed rate and rates range from 8.2% to 11.9%, depending on a borrower's credit score. The average rate after fees and bad debt is 8.3%, but if lenders are willing to take on riskier borrowers, they can potentially earn more.

With YES-Secure, average interest rates range from 8.4% for A* to 20% for E-rated borrowers.

Lenders are also credit checked and, once verified, they post the amount they are willing to loan on the website and the category of people they want to lend to.

Potential lenders then bid to lend to would-be borrowers and the borrower can choose to accept or decline each rate offered, in an eBay-style auction bid.

YES-Secure's founder, Dr Chandra Patni, says the company goes a step further than Zopa, by incorporating social networking into the process.

His site has a wider range of borrower categories, which, Patni says, provide a better opportunity for investors to set higher interest rates and make money.

Members build up social connections by recommending friends and colleagues to 'connect' with online.

For each contact added, a score is given depending on credit history. The more connections with a good credit score made, the higher the personal reliability score.

Of course, there are fees involved. Zopa lenders pay an annual fee of 1% on the money they loan, and borrowers pay a fixed fee of £124.50, added onto the value of their loan. YES-Secure lender fees are 0.96%, while borrowers pay £80 per loan.

Risk is inherent in this form of lending, because borrowers may not repay on time, or in full. But, average default rates are low: Zopa's is 0.7% and YES-Secure's is currently 0%.

However, if a lender was to lose their money, there is no access to the Financial Services Compensation Scheme.

That said, both companies take the same action as the major banks if the worst happens – a separate debt agency chases the loan and county court judgements (CCJs) can be issued.

Giles Andrews, co-founder and chief executive of Zopa, believes that the £100 million Zopa has lent is significant enough to warrant regulation. He is keen to push for more consumer protection as the market grows.

While Patni admits that peer-to-peer lending is no real threat to the banks – as it is still very niché – he says the concept remains attractive because lenders' higher interest rates are beating inflation.

And, he says, peer-to-peer lending could expand in the future to products such as mortgages.

Funding Circle

Funding Circle is another type of peer-to-peer lending. Set up in August, it specialises in loans to small businesses, rather than individuals.

Co-founder Andrew Mullinger explains that – as with Zopa and YES-Secure – risk is diversified because money is lent to a number of businesses, which must have been established for a minimum of two years and be UK-based.

They also need at least two years' filed accounts/proof of active trading and no outstanding CCJs of more than £250.

The main benefit of Funding Circle over Zopa and YES-Secure is its secondary market. At any point in the process, if a lender wants their money back, they can re-auction the loan.

Currently there are no fees for borrowers or lenders, but these will be introduced next year – including a completion fee of 2% of the loan amount, payable on acceptance.

Mullinger reassuringly points out that if borrowing companies cease trading, lenders are protected. They are covered by a loan service company that repays outstanding loans.

As the market develops, further specialised peer-to-peer lenders are likely to emerge. Andrews says Zopa welcomes competition, as it should help to 'normalise' peer-to-peer lending.

But Andy Deeks, managing consultant at Navigant Consulting, argues it will only attract a certain type of investor.

"It will always remain niché because most people will prefer to rely on high street banks. Most investors will only put a small amount in and it will appeal to people who might want to go against the grain and look for non-traditional investment methods."

He believes that while returns look attractive now, when the economic situation improves more people will return to traditional investing.

Dennis Hall, independent financial adviser at Yellowtail Financial Planning, sees Zopa and YES-Secure as an addition, rather than an alternative, to the banks.

He also warns that returns need to be high to justify time spent building a lending portfolio on one of these sites.

Peer-to-peer lending is undoubtedly attractive for income seekers looking for better returns. As lenders can set their own rates, they could earn anything up to 20% (with an E-graded borrower on YES-Secure) for the riskiest loan.

But pushing for high rates will diminish the number of borrowers and may result in riskier lending and defaults.

While the sites are an innovative way to make money, the lack of regulation and added risks mean that consumers should proceed with caution.

This article was originally published in Money Observer - Moneywise's sister publication - in October 2010

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