More and more savers are being tempted by social lending sites that promise a better return than the banks, but are these sites really worth the risk?
If you’re looking to get a good return on your savings without entering the world of investments, lending your cash to others through a social lending site could provide you with a better return.
But can these sites be trusted or are you just putting your hard earned cash at risk? Here’s a breakdown of the peaks and pitfalls of social lending.
What is social lending?
Social lending (also known as peer to peer lending) was 'officially' established in the UK in 2005 when the first social lending website was launched.
It works by matching people who need to borrow money with those willing to lend it in return for a decent rate of interest.
The idea is that by cutting out the high street banks ‘lenders’ will get a better return on their savings and 'borrowers' will pay less for a loan.
This means that, as a lender, your money isn’t held by the social lending site directly but lent out to borrowers at an agreed price, while as a borrower you repay you loan to the social lending site who then pass it back to your creditors.
How does it work?
There are two main social lending models:
1. Rating based
A borrower will apply for a loan directly from a social lending site. The website will assign the borrower a rating based on their credit history and search for members who are both willing to lend to them and able to offer a competitive rate. A loan will then be drawn up from the savings of suitable lenders.
2. Auction based
Borrowers advertise the amount they want to borrow and the term they'd like to repay over, lenders then bid to fund part of the loan. Once enough bids have been placed to fund the whole amount needed, the social lending site will pick the lenders that have asked for the lowest interest rate and set up the agreement. This method allows the borrower to explain why they need the loan and what they are willing to pay, while lenders can assess whether they want to lend out their money and what they’ll charge on a case by case basis.
What are the pros?
Better interest rates
For lenders:
If you lend money through a social lending website the return can be significantly greater than the amount you would earn in interest if your money was in a standard cash savings account.
The exact return you're able to achieve on your 'loan' will depend on who you are willing to lend to.
Borrowers are given a rating that's based on their credit score and therefore the risk they represent to lenders. You can usually charge a higher interest rate to high risk borrowers, but the potential profits are offset by the greater likelihood that they will default on their repayments.
For borrowers:
If you need a loan then you may be able to borrow at a lower rate than if you went to a high street bank.
This is particularly the case if you're looking to borrow a smaller amount over a shorter period, and if you have a poor credit history as social lending sites tend to be far cheaper than payday loan companies.
What's more, in most cases there are no early repayment charges so you can repay your loan at anytime without being penalised.
Shunning high street banks
For lenders:
Lending money through a social lending website means that you could be helping people or small businesses who need a loan rather than giving the banks money to play with.
For borrowers:
If you can’t get a loan from the high street then social lending may provide a more forgiving source of credit, where you can explain to other members why you need to borrow the money and why you may have a poor credit rating.
What are the cons?
Risk
For lenders:
If you lend through a social lending website the risk to your money is significantly greater than if it was held in a cash savings account; in fact it is more akin to placing your money in stocks or shares.
The main reason for this is the potential for people to default on loan repayments. This could leave you waiting a long time to get your cash back, or even mean losing your money altogether.
You can control the level of risk you take to a point as social lending websites rate borrowers depending on their credit score; usually between A* (an ideal borrower) and E (a higher risk borrower).
You are generally able to specify the minimum rating a borrower must have before your money can be lent to them - this allows you to control the risk to your money to a certain extent.
Additionally, in most cases your money will be split, pooled with money from other lenders and used to fund a number of loans to a number of different borrowers. This helps to mitigate risk, as if one borrower defaults on their loan you'll only lose a small part of the amount you invested.
Most social lending sites also employ a collections team to chase outstanding loan payments if borrowers fall behind. However, there is no guarantee that they will be able to secure repayment so it's possible that you could lose all of the money you've lent.
No guarantee
For lenders:
Social lending sites are not covered by the UK deposit protection scheme, so if the company went bust or if the borrower defaulted you would have no guarantee from the government that you’d get your money back.
Most social lending sites will hold your money in a separate client account when it is not being lent out, which would, in theory at least, protect your deposits should the company fold. However, money held in this way wouldn't accrue interest - it's only designed to hold cash which is waiting to be lent to borrowers.
Once your money is lent out it will be transferred to the borrower meaning you have little protection.
No FSA regulation
For lenders:
At present, social lending websites don’t fall under the regulation of the FSA.
This means if you have a complaint or feel mistreated by the site you would not be able to refer your complaint to the financial ombudsman, should your dealings with a company fail.
However, social lending sites that are members of the Peer-to-Peer Finance Association do now adhere to government-approved guidelines.
Although this isn’t the same as FSA regulation, their Rules & Operating Principles will give you some reassurance about the standard of service you can expect, and the level of protection for users.
Not all social lending sites have agreed to these guidelines, so you need to check before you commit to lending or borrowing.
Tied in
For lenders:
Once you agree to a loan and your money is transferred to the borrower you are tied in for the duration of the loan.
As a result, if you need your cash you will either be unable to access it until the end of the loan or incur a penalty for withdrawing it before the end of the term.
So you would need to be sure that you didn’t need the funds for the duration of your agreement before committing your money.
For borrowers:
As a borrower you are also committed to make your monthly repayments on time and pay back the loan in full, in the same way as if you’d take out a loan with a high street bank.
Fail to make your repayments and you will not only damage your credit report but may face a visit from a collections agency, and ultimately end up in court.
Fees
For lenders:
When you lend money through a social lending website, you will not actually receive the exact interest rate you agree with the borrower. This is because the site itself is likely to take a cut of the interest you earn; usually around the 1% mark.
You need to remember to factor this in when looking at whether social lending is worth your while.
For borrowers:
As a borrower, you will not only pay interest in the same way as a normal loan but may also have to pay an underwriters fee to the social lending site which will add to the cost.
These are often above £100 and cover the cost of creating the loan agreement, sourcing members willing to lend you money and the websites fee.
Who are the main players?
Zopa
By far the largest social lending site, Zopa was the founder of the social lending business model back in 2005 and has now swelled to well over 500,000 members.
Funding Circle
Focused on providing loans for small UK businesses rather than issuing personal loans, Funding Circle promises an average return for savers of 8.3% per year.
Yes-Secure
Yes-Secure operates a bid system for its loans, where borrowers place a loan request and lenders make bids to fund the loan at their chosen interest rates. Once a loan is fully funded the cheapest bids make up the loan.
Rate-Setter
Set up in 2010, Rate-Setter offers the chance to loan money on a shorter term basis than other social lending sites.
Is social lending worth it?
On the surface social lending does promise a better return on your cash than many ordinary savings accounts; however that doesn’t mean you should plunge all your available money into social loans.
Instead you should consider whether you can really afford to speculate using social lending given the associated risk that you may lose your money.
If you already have a wide variety of investments and are comfortable with an element of risk then lending via a social lending site may provide a feasible investment alternative.
You can compare the best savings accounts using the money.co.uk savings tables to see exactly what the difference might be between a standard savings account and interest returns from social lending.
