It’s a tough time to be a saver.
While inflation has finally fallen to a point where you might just get a ‘real’ return on your savings if you have the right account, there’s no guarantee it will stay this low.
And it’s small consolation in any case: accountancy firm UHY Hacker and Young reckons that low interest rates have already cost UK savers £18bn, reports the Daily Mail.
Yet it’s not a fantastic time to be a borrower either. Compared to more usual times, the gap between the rate you’ll get on your savings, and the rate you have to pay to borrow money, is huge.
The average savings rate on savings accounts has fallen in the past four years, yet the rate on credit cards and overdrafts has gone up. And small and medium-sized firms, as the government keeps telling us, have few options available for borrowing.
This all boils down to banks, of course. Their balance sheets are tattered and torn. One way to try to repair themselves is to pay savers as little as possible for their money, then lend it out to only the most creditworthy customers for as much as they can justify.
This environment has been a nightmare for many. But it’s been a huge boost for the peer-to-peer (P2P – also known as ‘lend-to-save’) lending business. The idea is to cut out the banks by linking savers and lenders directly.
Since the pioneer in this area, Zopa.com, made its debut in 2005, P2P in the UK has grown fast, with over £250m lent out by the three biggest firms (Zopa, Funding Circle and Ratesetter). The government is a big fan of the idea too. Indeed, it has announced plans to dish out £100m of loans to small firms via the industry.
So should you be getting into the P2P business yourself? At the Albion Society’s “Modern Money” roundtable a few weeks ago I met Samir Desai, CEO of Funding Circle, and Alex Gowar, the CMO of Ratesetter, two of the three largest P2P companies, and spoke to them in more depth about what they can offer to savers.
Of the two, Funding Circle is the closest to the traditional P2P model, where savers choose to whom they lend. Of course, members are not left to their own devices entirely.
All firms are pre-screened to ensure that they meet minimum credit standards. In many cases directors, and / or major shareholders are also forced to guarantee payments, which means that they have to pay if their business goes under.
Funding Circle also gives the company its own rating and makes this information, along with credit scores, available to all members. It also takes care of the admin, charging the first 1% of interest in return.
The borrower can split their loan requests up into small amounts, starting from as little as £20. These are then auctioned off, like goods on eBay, with the lenders bidding for the loans. Clearly, the more demand there is to lend to a company, the cheaper its loan will end up being. Desai suggests that investors should take advantage of this to spread their risk over as many firms as possible.
While rates vary depending on the firm and the duration of the loans, Funding Circle claims that the average gross yield (before fees and debt) is 8.5%. According to data on its website, current bad debt amounts to 0.9% of total loans. The group estimates that, over their lifetime, 2.9% of loans will not be repaid.
Ratesetter does things slightly differently. Firstly, it deals with personal, rather than business loans. More importantly, as a lender, you do not directly judge borrower risk – you only choose the amount you want to lend and the duration of the loan.
Instead, Ratesetter does this job, charging borrowers a fee (in addition to a charge for using the service), based on the chances of default. All the fees are collected in a central fund that is used to cover any bad loans. Like Funding Circle, savers can start with a very small amount – in this case £10.
This means that savers are relying on overall defaults to be lower than the amount of money in the fund. Ratesetter claim that their two-step process, which uses credit rating agencies as well as personal contact with borrowers, ensures enough oversight. They also set minimum criteria (such as age, income and UK residency) that filter out the most risky loans at a very early stage.
The model that they use to estimate default risk is based around eight million historical credit records. Finally, they have designed the fund to be much bigger than the predicted default rate – just in case there is a spike in defaults.
At the moment it seems to be working. While the fund is roughly equal to 2.9% of the £25m in outstanding loans, the historic default rate is a tiny 0.28%. While Gowar admits that they think the default rate should be 1.4%, the high level of defaults during the 2007-09 periods may have led the models to be cautious. In any case, returns (net of fees equal to 10% of interest) go from 3.8%, to 7.7% pa, depending upon length of loan.
Of course, there is always Zopa, the largest, and longest-running, P2P firm in the UK. Instead of investing in a central fund, as with Ratesetter, or following the Funding Circle model of lending directly to individual firms, lenders specify the amount they want to lend, the length, the riskiness and the rate. The money is then split into smaller chunks. These are then automatically given to borrowers of the specified risk rating who are willing to take the rate offered.
Like Funding Circle, lenders are charged 1% of the value of the loans as a fee. Zopa claims that the average return net of tax and fees is 5.5% pa. Historic default rates vary from 0% for the highest rated loans for 12 months to 10.3% for 48-month loans to the most risky borrowers. The weighted average default rate is 0.7%.
What to be aware of
Our view on P2P lending is that it’s an interesting option for part of your portfolio. The returns are reasonably attractive and the idea of doing your bit to lend to individuals and businesses without the banks taking a cut of the action is quite appealing.
However, it’s important to remember that these aren’t bank accounts. Your capital is not guaranteed, and you are not covered by the Financial Services Compensation Scheme (FSCS) – you can lose money doing this. Also, currently loans through P2P firms cannot be put in your Individual Savings Account (Isa) wrapper, so you’ll have to pay tax on any income.
And none of these businesses, not even Zopa, has realistically been around for long enough to provide users with decent conclusions about what might happen over a typical business cycle.
So if you have some money earmarked for investing in corporate bonds for example, we’d certainly consider putting some of that towards P2P. Just make sure you understand how the system works and keep an eye on bad debt levels.
As for which to go for, it really depends on whether you want to lend to businesses (Funding Circle) or individuals (Ratesetter, Zopa). Funding Circle and Zopa also offer the ability to sell a loan before it matures (useful if you need access to your money), while Ratesetter is arguably the simplest to use as it doesn’t require you to make judgements about the credit worthiness of potential borrowers.