A new way to bypass the banks

For all the nagging by politicians, banks still aren't lending to small firms. Business lending shrunk for the fifth month in a row in July, according to the Bank of England. Meanwhile, the pitiful rates paid on savings accounts mean that savers are still seeing inflation eat away at their cash.

EnterFunding Circle. This new social (or 'peer-to-peer') lender is offering the chance to get returns of up to 9% a year by lending your cash direct to small firms. The idea isn't new. Zopa has been providing a similar online service since 2005. Both lenders offer the chance to bypass the banks and lend your money direct Funding Circle to businesses, Zopa to people. But as Dan Hyde notes on Thisismoney.co.uk, Funding Circle "comes with a unique twist": you can get your money back when you like.

Here's how it works. You decide what you want to lend the typical minimum is £400. The cash is lent out for either one or three years and repaid with interest each month. The firm's 'Autobid' tool matches lenders and borrowers and aims to spread your savings around 20 cash-hungry businesses (for now it's nearer 14, due to a lack of vetted borrowers). The rate you earn (between 6% and 9%) depends on the risk you take.

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There are three tiers, from A+ rated firms (with an expected bad debt rate of just 0.6%) through A rated (1.5%) to B rated (2.3%). When it comes to cashing in, with Zopa you are tied in for the minimum period. But Funding Circle runs a market place for loans that have been earmarked for sale. In effect, you hope someone else will buy you out before the term ends.

So what's the catch? The returns aren't quite as good as they look. You may get a gross rate of up to 9%, but for lower-risk lending it'll be more like 6%-7%. Knock off a 1% management fee and a 1% early redemption fee (waived for 2010) and your net return is more like 4%-5% (before tax). Then there's risk. Diversifying across 20 firms is sensible, but if we get a double-dip recession you could still face steep losses if borrowers go bust there are often sound reasons why a commercial bank has refused to offer credit, regardless of "evil bankers" headlines. Finally, it's not covered by the Financial Services Compensation Scheme (FSCS) £50,000 savings account guarantee.

That's not to say that we'd avoid social lending altogether. As long as you always remember that your capital is at risk, it's an interesting way to invest. But given that the social lending industry is still fairly new, and we could face a double-dip, we'd stick to lending small amounts for now.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.