Beat miserly bank returns by going social

Cutting out the middle man and becoming the lender yourself is growing in popularity, but is it safe? Chiara Cavaglieri and Julian Knight report

New Year always brings well-intentioned resolutions but if you're fed up with the banks and want to find a new way to save or borrow in 2012, social lending could be the answer.

Instead of dealing with a bank or building society these sites enable you to lend and borrow from your peers instead. The headline rates available are impressive. However, only a matter of weeks ago one of these sites – Quakle – collapsed, so is it really safe?

There aren't many of these peer-to-peer sites around. Quakle had only been around for a year and its demise has understandably prompted fears that this type of lending is too high risk, but this doesn't mean you should be put off entirely.

"Social lending still has a place when looking for loan. Zopa, Funding Circle and Ratesetter have leading-edge technology for completing loans online and they offer competitive rates," says Nicola Winter from loan comparison site Freedom Finance.

Social lending is fairly straightforward; companies create a lending community so that savers looking to beat the paltry high-street rates can lend their money to borrowers who are equally disillusioned with the banks. The biggest P2P site is Zopa which has around 500,000 members but RateSetter has already amassed 75,000 customers after one year and Funding Circle offers a twist on the usual model by enabling people to lend to small businesses instead of individual borrowers.

Social lending cuts out the middle man. Banks and building societies make a tidy sum by lending money deposited by their savers who are in turn paid interest for the use of their money. Lately, however, returns have been so miserly that it would seem there is a place for an organisation which could cut out the banks, enabling savers to lend to borrowers directly and enjoy better rates.

With Zopa, borrowers are rated according to risk (A*, A, B, C or Young) and loans last for 36 or 60 months with a £5,000 loan over three years for an A* borrower paying an APR of only 7.7 per cent. Zopa lenders on average get 6.4 per cent, including an annual fee of 1 per cent of the loan amount.

In terms of "bad debt" – borrowers defaulting on loans at a loss to lenders – the big three have very healthy reputations. All borrowers are identity-checked, credit scored and risk-assessed and the companies say that only prime borrowers are accepted. Your money is also spread out to minimise risk; at Zopa anybody lending £500 or more has their money spread across at least 50 borrowers. RateSetter also has its Provision Fund – a pot of cash – to cover borrowers falling behind on payments to protect lenders against losing any money.

"The leading P2P providers recognise that the biggest concern for our users is risk; 'What happens if a borrower doesn't repay his or her loan?' For that reason stringent measures are in place to manage bad debt," says Alex Gowar from RateSetter.

Also, in the summer the big three set up a new trade body, P2P Finance Association, designed to safeguard consumers. Members agree to use thorough credit-risk assessment processes and must have a minimum capital base and a solid repayment model in place in the event of going bust. It's important to note that Quakle couldn't meet the criteria and did not sign up to this and – as well as not being a member – Quakle was unusual among the other P2P sites because it relied on social media profiles and rankings to determine how risky borrowers were, instead of personal and business credit information. This meant more borrowers defaulted and although only a small amount of money was lent out (around £16,000) these lenders could struggle to get their money back.

This self-governing trade body is certainly welcome but the crux of the matter is that this is still in no way comparable to Financial Services Authority regulation and if you plough your money into any of these sites you are not protected under the Financial Services Compensation Scheme which guarantees up to £85,000 of deposits if a company fails.

And in the current environment with the eurozone in crisis and banks calling on central banks for extra funding there has never been a more crucial time for deposits to have some sort of protection. So, not only do lenders run the risk of borrowers defaulting and failing to make their repayments, if the loans company goes under, you could potentially lose all of your money. With this in mind, the advice is to ensure that you don't make social lending sites a vehicle for all of your savings.

"Savers should not consider social lending to be akin to a savings account – it is an investment, the value of which can in effect go down as well as up, where money is tied up for a period (typically three to five years) and there is the risk of loss.

"Social lending should only form part of a portfolio and investors should not be over exposed," says Danny Cox of independent financial adviser Hargreaves Lansdown.

If you understand and accept the associated risks, there is no denying that the returns are appealing and that social lending can be a handy way to diversify your portfolio. What's more, many investors may feel that in these straitened times it's a good thing to be helping out individuals who will have difficulty to get loans from the more mainstream institutions.

But beware of new companies popping up until they are well established and have signed up to the P2P Finance Association. Or, if you want to play it safe, wait with fingers crossed for social lending to come under the FSA's jurisdiction.

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