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Peer-to-peer lending: risks and returns
June 28, 2011 | By:

Borrowers and lenders can both get better deals through peer-to-peer lending, and it's an increasingly popular alternative to traditional lending and borrowing. Sheila Prophet investigates

LOAN ARRANGERS Stack-Of-British-Pound-Coins-620 BigstockWith conventional savings rates ranging from pathetic to insulting, peer to peer – or social – lending is becoming an increasingly popular alternative.

The obvious reason is the returns on offer, which are typically between seven and ten per cent, depending on the level of risk the lender is prepared to take on. But for many people there is the added attraction of bypassing the unpopular big banks and, in some cases, being able to assist people who have been rejected by those very institutions.

Peer to peer, or P2P, lending means cutting out the middle man (the bank or building society) and putting together people who want to borrow money with those prepared to lend it. The companies involved are matchmaking services, which make their money from the fees charged to customers.

In the past few years, a number of peer to peer companies have launched, each with their own variation on the theme. Some, such as Funding Circle and the cleverly named Thincats.com, provide loans to businesses. Others, such as Yes-secure.com and Ratesetter.com, provide loans to individuals who have been credit checked in advance.

The best known and longest established company is Zopa.com, which has been in operation since March 2005. It has over half a million members, who collectively have lent other people more than £135 million.

Zopa (which stands for Zone of Possible Agreement) allows borrowers to access low-cost loans that they might not be able to find elsewhere. A typical APR on a £5,000 loan over three years is 8.4 per cent. At the other end of the deal, lenders providing amounts from £10 to over £25,000 get an average return of 7.3 per cent before tax.

The twist with social lending, however, is that lenders can choose their own rate of return, depending on the length of the loan and the level of risk they are comfortable with. Zopa, for example, divides borrowers into five ‘market’ levels, from A*, who are the safest with a good credit rating, through to A, B, C and Young, who are borrowers aged 20 to 25 with very little financial history. (Lending money to borrowers in this market means potential returns could rise to over 11 per cent, but the risk of them defaulting is also much higher.)

Zopa says its default rate is between 0.4 and 5.2 per cent. Funding Circle, which places cash with small businesses, says its rate is from 0.6 to 2.3 per cent. But both companies emphasise that the risk is controlled by the funds being spread out among lots of borrowers. Zopa says if you lend more than £500 your risk is spread among at least 50 borrowers. This means you won’t lose your capital if some borrowers default; it will simply reduce your rate of return.

Peer to peer lending cannot be considered as secure as a conventional bank account. The companies involved have been issued Consumer Credit Licences, or CCLs, by the Office of Fair Trading but are not yet regulated by the Financial Services Authority. (Zopa has campaigned for regulation to be put in place.)

Martyn Saville, the credit expert for Which? Magazine, which recently reviewed a number of P2P websites, says: “Depositers should be aware that the Financial Services Compensation Scheme does not cover peer to peer lenders, so your money is not 100 per cent secure. I urge anyone thinking of putting their money in a peer to peer loan to view it as an investment rather than a savings deposit. That way you will be able to compare the increased risks with the higher rewards. If you’re happy with the risks, peer to peer lending can be a useful part of a well-diversified investment portfolio.”

Which P2P lender is right for you?

The differences between P2P lenders are often hidden in the small print, so here are the key questions to ask before you hand over your hard-earned cash:

Does the company charge lenders a flat fee or a percentage of the amount they lend?

What’s the minimum and maximum you can lend?

How long will the loan last?

Can you access your money early and will this cost extra?

What are the company’s default rates?

What happens if the company itself goes bust?  (Some companies have agreements with other organisations to take over if the worst should happen.)

Further reading: Which? guide to peer-to-peer lending