Peer-to-peer lending enables savers to lend money and achieve higher returns than if they deposited their money with a bank or building society. The system benefits borrowers too, as they get access to lower cost loans than they would if they borrowed through a bank (you can read more about this at the end of this article).
Peer-to-peer schemes have soared in popularity in recent months, with consumer loans made via the websites having just hit the £500m mark. Here, we take a closer look at how peer-to-peer lending works, as well as the potential returns and risks involved... .
All peer-to-peer lenders are not the same
If you choose to invest with a peer-to-peer lender in order to boost your savings returns, it pays to look carefully under the bonnet of the particular scheme you have chosen.
Different providers charge different fees and offer varying levels of protection, so don't assume they are all the same.
Alex Gowar, spokesman for one peer-to-peer lender, RateSetter.com, said: "The key piece of advice I'd give to someone who is considering peer-to-peer is to carefully reflect on the rate you can expect to earn. While contracts are fixed, rates of return can vary as they can be affected by bad debt and late payments. So when choosing a peer-to-peer operator, it makes sense to understand the risks and protections that are in place."
What sort of returns can I expect?
The returns you can generate from investing with a peer-to-peer lender will depend on how long you can afford to tie your money up for, as well as any charges which may be deducted and the risks involved.
For example, the average net return before tax across all investors lending for 180 days or more through Funding Circle, another peer-to-peer site, is 6.20%. This rate includes all earnings and is calculated after fees and bad debt. However, this isn't necessarily the actual rate you will get. This is because the returns you achieve will depend on the exact rates you choose to lend at, the risk grade of the businesses you lend to, and any losses you might experience. Businesses are graded A+ through to C, with A+ businesses being the lowest risk and C being the riskiest.
There is a 1% annual servicing fee and on average it take two days to access your money, which you can do by selling parts of your loan to other investors. If you sell a loan part, there is a 0.25% sale fee.
The minimum amount you can invest with Funding Circle is £20 and there is no maximum, so you can invest as much as you want.
Zopa, another major peer-to-peer lender, also charges an annual fee of 1% on the money you lend, and the rates shown on its website are inclusive of fees.
Similarly, with RateSetter, the rates shown are inclusive of fees, which are equivalent to 10% of the interest you receive.
If you are prepared to tie your money up for five years, then RateSetter's 5 Year Income account offers a return of 4.80% on your investment, repaid in equal monthly instalments, which can either be reinvested or taken as an income.
The minimum amount you can lend is £20, and there is no maximum. If you don't want to tie your money up for this long, RateSetter's 3 Year Income account pays 4.00% fixed, again inclusive of fees.
Alternatively, the RateSetter 1 Year Bond pays a fixed rate of 3.10% before tax - not bad when you consider the best 1-year fixed rate from a conventional savings provider is just 2.10% (annual equivalent rate) from Kent Reliance Building Society.
If you don't want to tie up your savings for a long period of time, then RateSetter offers a Monthly Access option, which only requires a short-term commitment of 30 days investing. You can earn 2.40% on your investment, and at the end of the month, you can roll your contract over or you can withdraw your funds.
How safe is your money?
Money invested with peer-to-peer lenders is not protected by the Financial Services Compensation Scheme, so there are definite risks involved in choosing to save with a peer-to-peer lender rather than a conventional savings provider.
However, peer-to-peer lenders do vet their borrowers very carefully, so your money is unlikely to be lent to anyone with less than an excellent credit rating. Funding Circle, for example, has very low annual bad debt rates of below 0.50%.
RateSetter claims it is unique in peer-to-peer lending as the only operator to have returned every penny of capital and interest to every single lender. It is able to do this because of its Provision Fund, which lenders contribute to via their 'credit rate'. If a payment is missed, then lenders can make a claim through the fund to ensure that that they don't lose out.
Zopa recently introduced a similar scheme to help protect savers. The 'Zopa Safeguard' is a fund held in trust by a not-for-profit organisation, which means Zopa has no rights to the money in it. So if a borrower you lend to through the site is then unable to pay back their loan, the Zopa Safeguard will step in and repay all the money you are owed.
Peer-to-peer lending benefits both borrowers and savers
As mentioned earlier, it's not just savers who can end up quids-in using peer-to-peer providers - borrowers can benefits from market-leading loan rates too. For example, Zopa has just slashed the rate on loans between £7,500 up to £10,000 to a representative APR (annual percentage rate) of 4.9%, the lowest rate ever on this size of loan.
Giles Andrews, CEO of Zopa, said: "By going under 5% this signals an exciting opportunity for us and future for the peer-to-peer industry as a mainstream option for borrowers looking for unsecured personal loans."
You can read more about the new loan in Laura Howard's article: Loan rates hit new all-time low of 4.9%. You'll need to hurry, however, if you want to take advantage of this deal, as it is only around until May 22.
Please note: Any rates or deals mentioned in this article were available at the time of writing. Click on a highlighted product and apply direct.