A new banking alternative is emerging into the mainstream as savers cast around for decent rates in an otherwise subdued market and borrowers dodge the squeeze.
Lend-to-Save websites, otherwise known as peer-to-peer firms, cut out the middle man (i.e the bank) to match borrowers with lenders – in theory a win-win scenario for both sides because each have access to better rates than they might otherwise find.
But is lend-to-save really the way to beat low savings rates, or is it too risky? We take a look at why both borrowers and savers are turning to the schemes that are halfway between saving and investing.
Lend-to-save: Schemes that offer savers the opportunity to match their needs with borrowers are growing in popularity
The lend-to-save story
The first lend-to-save firm, Zopa was launched in the UK in 2005, and along with the other two most established lend-to-save companies, Funding Circle and RateSetter, it has experienced huge interest from investors comfortable with a little risk.
Savers are enticed by typical returns of around 8 per cent, rather than the savings market average of 3 per cent, or less.
The benefits for borrowers are that interest rates can be lower than those charged by traditional lenders and that there are no early repayment penalties.
This is particularly attractive to the self-employed and others who, because they have fluctuating earnings, may find it difficult to borrow from the banks and may also wish to repay loans early.
There have been some casualties along the way. A minor lend-to-Save firm Quakle, for example, went bust in 2011 leaving savers wondering whether they would get their cash back. The firm assured them they would and that it was ringfenced, but this highlighted two of the major points of contention for prospective investors.
Firstly, unlike with a savings account you do not benefit from the Financial Services Compensation Scheme savings deposit protection of up to £85,000, if someone defaults on your loan then you take the hit.
Secondly, even if you treat lend-to-save as an investment, as the industry is not FSA regulated there is no official safety net making sure your money is protected if the firm goes bust.
To tackle this, the Big Three, Zopa, Funding Circle and RateSetter have established their own risk models and a seemingly robust industry association with tough rules on joining (see below). They also apply tough criteria to who they will lend to.
And the extra risk over saving has not put people off, with lend-to-save proving something of a goldmine. Figures released for January 2013 showed it to be a record month for the UK lend-to-Save industry as a whole - nearly £20m was matched between prime consumer borrowers and savers looking for a better deal.
NOT SAVING OR INVESTING - MORE LIKE A CROSS BETWEEN THE TWO
Because lend-to-save firms are outside the remit of the Financial Services Compensation Scheme (see below), lending your money via these online companies can not really be described as 'saving', because there is an element of risk.
As such, in theory the concept is more like investing, as you are risking money. The return on your investment is entirely dependent on the solvency of the people it is being lent to, although individual firms have their own ways of trying to minimise the pain of defaults.
Ultimately, lend-to-save is a cross between saving and investing. You must accept that there is a potential that you will lose money but the firms are replicating the basic principle of saving - with their own safety nets in place.
Those who opt to put money in must weigh up whether the extra reward over a savings account merits the extra risk and should remember to never put all your eggs in one basket.
Who can borrow, and how are investors protected?
The Big Three all operate a strict credit checking policy - 85 per cent of those who apply for a RateSetter loan, for example, are rejected.
In addition, concerns about the lack of protection and regulation have convinced Zopa, Ratesetter and Funding Circle to take action. So far, they have set up a voluntary trade association and are in talks with Treasury officials about possible regulation, although nothing has yet been agreed.
The industry body, the Peer2Peer Finance Association is designed to protect consumers by ensuring a set of minimum standards. Zopa, Funding Circle and RateSetter are the founding – and as yet the only - members.
In our view, checking for association membership is crucial. It’s a self-governing industry body, so does not carry the same weight as regulation by the Financial Conduct Authority (which replaced the FSA along with the PRA) – something the industry wants but lacks as yet – and is currently the best benchmark for those considering lending.
Crucially with social lending, unlike with a savings deposit account your money is not protected by the Financial Services Compensation Scheme, which guarantees savers get up to £85,000 of their money back if a UK bank goes bust).
To be part of the P2P Finance Association, a lender MUST have both a strong capital base (something missing at Quakle) and a solid plan in place to make sure lenders are repaid if the firm goes bust.
Funding Circle, for example, employs Link Financial, an S&P-rated loan servicer, which would step in if the firm could no longer trade. This would ensure business as usual for existing lenders and borrowers. Zopa and RateSetter have their own arrangements in place as part of the association requirements.
Commission and fees
Although headline rates are a huge draw, borrowers and lenders will need to look out for charges and fees.
Despite these costs, lend-to-save still offers slightly better rates than are often available through mainstream savings and borrowing markets. Each company charges different amounts, but all depend on the amount you lend or borrow, and how long for.
HOW DO THE BIG THREE COMPARE?
Zopa
The Big Three: How do they compare?
Best for: Most established site
Loans accepted: More than £290 million
Investors
Cash loaned to: Individuals
Minimum lend: £10
Length of term: Up to five years
Easy access? Yes, usually within days
Rates: 5.1 per cent average for the past twelve months (after fees, before tax and bad debts)
Fees: 1 per cent of money lent per year; plus 1 per cent charge on loans sold on to others.
Borrowers
Rates: The typical interest rate is 6.7 per cent
Extra fees: Borrowers pay a fixed fee of between £0 and £190 dependent on the size and term of their loan, and this charge is reflected in the APR they are quoted and charged.
Early repayment fees: None
Minimum/Maximum borrow: Minimum is £1,000, maximum £15,000
Length of term: Minimum one year, maximum five years
What else?
Zopa was the first online lend-to-save firm anywhere in the world when it launched in the UK in 2005, setting a benchmark for others to follow.
Now eight years old, it has arranged more than £280m in loans, and is currently arranging more than £10 million per month in new loans.
Over the past twelve months, Zopa lenders have earned an average return of 5.4 per cent a year after charges and bad debts. Its annual default rate lies just below 0.5 per cent.
Each month, lenders receive repayments from their borrowers, made up of the interest they are owed and a small portion of the outstanding capital. These payments can be immediately reinvested as new loans or left in the customer’s account to be lent in future, or withdrawn.
If a borrower does fall behind with their repayments for any reason, Zopa employs a collections agency to chase them - just like a bank might.
How do I get my money back quickly?
Zopa allows savers to get their cash back early with its Rapid Return function. Savers can cash out some, or all, of their loans but with an extra 1 per cent fee added. Essentially, another lender steps in and takes on your loan part, earning the interest you give up. If a borrower has ever missed a repayment on the loan, it doesn't qualify for Rapid Return use, though.
Do you have money to invest? Find out more about your options with Zopa
Want to borrow via Zopa? Find out more here
RateSetter
Best for: Backed by a fallback fund
Loans approved: £67,802,225
Lenders
Cash loaned to: Individuals
Minimum lend: £10
Length of term: Monthly or up to five years
Easy access? Yes
Rates: Currently 5.4 per cent on a five-year market, 4.3 per cent on a three-year, 3.1 per cent on a one-year and 2.2 per cent on monthly markets.
Fees: Lenders pay 10 per cent of the interest they earn to RateSetter. This is already included in the rates.
Borrowers
Interest rates: Average rates fall between 5.5 per cent and 12 per cent.
Fees: Borrowers pay a loan arrangement fee (RateSetter’s revenue), which is included as part of the total cost of the loan.
In addition, each borrower pays a 'credit rate'. This rate is calculated as a percentage of the loan (from 0.5 per cent to 4 per cent), based on their credit history. This fee is not RateSetter revenue; it is paid into a ring-fenced account called the Provision Fund.
There is nothing to pay up front, all the fees are spread out over the monthly repayments and are included in the total amount repayable.
These costs are dependent on term and usually come to between £100 and £180.
Early repayment fees: None. Borrowers can pay off all or part of their loan early. They can make additional payments, increase monthly installments or repay their loan off in full.
Minimum/maximum borrow: RateSetter offers loans from £1,000 to £25,000. The amount will depend on your circumstances.
Length of term: Monthly or up to five years
Anything else?
BUT ZOPA ALSO CLAIMS TO HAVE THE LOWEST DEFAULTS
Zopa, too, claims to offer the lowest default rates in the L2S market.
As Martin Campbell explains: 'Ratesetter has only issued loans for just over two years.
'Therefore most of their loans haven't even run to the end of their course. Typically, loans do not default in the first 12 months. So Ratesetter don't know what that default rate will actually be in the end.
'We have been going for eight years and have lent over £280m so we have large amounts of historical data to measure.
'Moneysavingexpert recently covered P2P lending and measured lifetime bad debt over the same period (two years) for each company, showing that Zopa's default was under 0.2% whereas Ratesetter's was 0.5%.'
RateSetter claims to offer the lowest default rates in the lend-to-save sector at 0.37 per cent of its loans book, even before factoring in its Provision Fund model.
Borrowers on RateSetter contribute to this £928,547 fund, which is called on in the event of a missed payment or default.
It is not a guarantee, but is managed on behalf of all lenders and has met every claim that has been asked of it.
This means that every lender on RateSetter has received every penny of capital and interest expected.
The fund is a separate entity, ring-fenced from RateSetter’s business, and managed on behalf of all lenders.
How do I get my money back quickly?
One relatively new piece of functionality designed to increase liquidity for lenders is the Sell-Out function that allows lenders to exit contracts early, for a fee.
Do you have money to invest? Find out more about your options with RateSetter
Want to borrow via RateSetter? Find out more here
Funding circle
Best for: Highest average interest rates
Loans accepted: £97,627,160
Investors
Cash loaned to: Small businesses
Minimum lend: £20
Length of term: Up to five years
Easy access? Yes
Rates: 8.8 per cent. Average net returns after fees and bad debts is between 6 per cent and 7 per cent
Fees: 1 per cent monthly fee, 0.25 per cent sale fee
Borrowers
Rates: Average rates fall between 7.1 per cent and 9.4 per cent across risk bands.
Funding Circle operates an auction where people bid the amount of money they want to lend at an interest rate they wish to earn. This ensures borrowers always get the lowest rate possible. Average rates are between 6.5 and 10 per cent depending on the business. Each business is allocated a risk band which ranges from A+ through to C.
Extra fees: Business loans cost 2 per cent for a one year loan, 3 per cent for a three year loan and 4 per cent for a five year loan. Large asset purchase loans cost 5 per cent of the amount borrowed.
Criteria: minimum annual turnover of £100,000, businesses need to be limited companies or LLPs and have 2+ years’ filed accounts with companies house in order to apply
Early repayment fees: None
Length of term: Minimum 12 months, up to five years
Size of loan: Minimum £5,000, maximum £500,000.
What else?
Funding Circle was established in August 2010 and enables savers to lend cash direct to small businesses.
It only deals with creditworthy SMEs in the UK, many of whom have been left out to dry by the banks.
As well as winning numerous innovation awards, Funding Circle's bid to help small businesses has been talked highly of by the Government. In December, 2012 the Department of Business Innovation and Skills confirmed plans to lend £20 million to small business through Funding Circle. Lancashire County Council and Huddersfield University also lend through Funding Circle.
Funding Circle's Autobid tool automatically places bids according to the criteria lenders have set. Lenders can choose the average rate they wish to offer, which types of businesses they want to lend to, and the maximum percentage of their portfolio to be lent to any one business.
However, because Funding Circle deals with businesses, the default rate is slightly higher. Actual bad debt currently stands at 1.6 per cent.
In the unlikely event that Funding Circle ceases trading, an S&P rated loans servicer would step in and continue to collect repayments from borrowers, and distribute these to lenders.
How do I get my money back quickly?
There is an easy access function, something it offered before Zopa, where lenders can sell loan parts to other lenders. This can be done manually or using an automatic tool. On average it takes two days to sell loan parts sold at the value a lender paid for them.
Do you want to find out about investing in small businesses? Click here for more on Funding Circle
SPREADING YOUR RISK
As part of investing via lend-to-save, it’s important to remember that a percentage of borrowers, or businesses, will be unable to repay their loan.
Funding Circle allows you to cut your loan into smaller chunks so that your risk is diversified - you can lend as little as £20 per business.
It also allows you to buy parts of existing loans from other investors, allowing you to diversify your portfolio even further. This is an added benefit for those who want to access their money quickly, although you must pay a 0.25 per cent fee to sell off part of your loan.
Funding circle also grades each business on its risk level to make it easy to compare high and low risk. Returns are directly linked to this risk.
Zopa, too, diversifies your risk by spreading loans among borrowers, and rating each on risk.
So, if one borrower doesn't stump up, the hit on your stash isn't catastrophic – it should just bump down your rate a bit. You can bolster this yourself by lending in different markets (they grade borrowers by credit score), or using multiple peer-to-peer sites.
RateSetter, on the other hand, does not split your loans across multiple borrowers. Its provision fund is there to mitigate the risk of individual Borrowers defaulting – if a borrower fails to pay, then the provision fund steps in to compensate the saver.
Remember that ultimately whatever provisions put in place by providers, this does not carry the official protection of a savings account and you need to weigh up whether the extra return you are getting is worth the extra risk you must take.