Ratesetter and Funding Circle lead the way in peer-to-peer lending

Since they first arrived on the scene six years ago, peer-to-peer lending companies have created a whole new lending world. There are now several players in the market, but the big three are Zopa, Funding Circle and RateSetter. These firms allow individuals, or small businesses, to borrow money from other individuals without the intervention of a bank.

For borrowers the service has become increasingly vital, as loans from traditional sources such as banks or building societies have dried up in the wake of the banking crisis.

People are able to borrow money at a much lower rate than they would find through traditional means – usually around 8% APR. In comparison, the best rate available from high street lenders is around 9%; but that is only available for people with squeaky-clean credit records – anyone else can expect a rate closer to 15% or 20%.

Case study

One person who has really benefited from social lending is John Bold, 39, from Ellesmere Port. He had debts of £1,300 built up on a Vanquis credit card with a rate of close to 50%.

When he started shopping around for a personal loan to consolidate that debt he was quoted rates ranging from 18% to 24%; then he saw an advert for Zopa. He was given a rate of 13.9% including all fees, and was delighted with the service. "The best part of it was that I could overpay without penalty, so whenever I had a spare £20 I would log in to Zopa and pay off a bit more of my debt," he says.

As for lenders, if they are prepared to take the risk, they can see returns of around 8.3% over the period of the loan - which can be anything from one to five years, depending on which company you use.

Mark Barry-Jackson, 62, from Surrey has been very impressed by Funding Circle. "I put in £500 last November, but it wasn't long before I topped it up to £10,000 after receiving some money from a drawdown arrangement – having enjoyed an average gross yield of 9.4%."

Given that the best buy savings accounts offer less than 5%, that's a fantastic rate of return.

How to get started

To get started, borrowers set out their proposal stating how much money they need to raise (up to £15,000 with Zopa) and give some information so the firm can perform a credit check. Depending on the results of your credit check you will either be rejected or accepted and classified based on risk. This will also affect what interest rate you get.

Those deemed safest are rated A* and get the lowest interest rates. Lenders just have to state how much they are prepared to lend, and at what rate. Then the website matches lenders' money with suitable borrowers.

For borrowers it is important to note that in most cases peer-to-peer lenders aren't likely to lend to you if the banks have turned you down. They tend to be very selective, as they want to protect their lenders' money.

However, Yes-Secure, set up last year, aims to lend to people who struggle to get fi nance elsewhere. As a result its interest rates tend to be higher, typically starting at 13.25%.

The question for most lenders is how safe is their money?

If the person you've lent money to does a runner, will you be out of pocket? This varies with each company, but with the big players such as Zopa or Funding Circle, if a borrower defaults on payments a collection agency is brought in to chase them - just as with a high street bank. Moreover, lenders' money is split and lent to several borrowers in order to minimise the risk. The chances of a borrower defaulting are very low too – RateSetter states that all its lenders get their money back.

But what about if something goes wrong with the actual lending company? The Office of Fair Trading regulates all the firms, but lenders' money isn't covered under a compensation scheme, as ordinary bank deposits are. If the lending company was to go bust administrators would be required to ensure borrowers continued to repay their loans, but the exact details are unknown as a peer-to-peer lender has yet to go bust.

Zopa, Funding Circle and RateSetter are all well funded and have set up a self-regulatory body to maintain high standards across the industry.

So far the peer-to-peer formula is working. Zopa recently celebrated having loaned out £150 million. Giles Andrews, its chief executive, is the fi rst to admit that part of the reason for the low default rate is that the lenders are "incredibly selective" about who they lend to, but he also says that a human element plays a part: "We have evidence that people recognise that they are borrowing from real people so prioritise the repayments."

Peer-to-peer lending now makes up around 2% of the unsecured personal loan market, but it will be a while before the banks are worried about any competition.

"Social lending is a new and emergent sector of the lending market which we welcome and are watching with interest," says Nathan Hatch, a spokesperson for Lloyds Banking Group, but he adds that it isn't affecting the way Lloyds operates its loans department.

While the big banks remain reluctant to lend out money and savings rates remain low, peer-to-peer lenders are filling a vital role in the market.

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