How safe is social lending?

Britain's ground-breaking 'social lending' exchange is enjoying a boom in business thanks to the credit crunch. So is buying unsecured consumer debt worth the risk? asks Simon Wilson.

Looking for a decent rate of return on cash and not frightened of lending your money to someone you don't know? Zopa is a unique online exchange that matches up cash-rich individuals directly with needy borrowers seeking modest loans. The name of the business comes from the "zone of possible agreement" between two parties in a negotiation. The idea is that the market sets the going rate, and both lenders and borrowers get a better deal by avoiding using an overheads-heavy, profiteering bank.

How Zopa works

Lenders can lend from just £10 up to £25,000 (or even more if you spend £380 on a consumer credit licence; Zopa will tell you how). You set the rate at which you are prepared to lend, depending on the risk profile of potential borrowers, and borrowers take up the best offers. It's like a mini version of the corporate bond market, where investors set the rate at which they buy a company's debt based on its perceived creditworthiness.

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On Zopa, there are five categories of risk profile: the riskier the borrower's credit profile, the higher the rate of return to the lender (always subject to a 1% annual charge). Zopa lenders can look at the 'listings' feature, where borrowers can put up a photo, explain why they want the cash, and answer questions. Borrowers may borrow up to £15,000, and pay a flat fee of £94.25 for the privilege.

Social lending: risk versus reward

All this might sound risky, but it works. MoneyWeek first featured Zopa in the week it launched back in March 2005, and we gave it an encouraging, if cautious, welcome. After all, Zopa in effect puts a high-risk asset class unsecured consumer debt within reach of private investors for the first time. Naturally, there are potential hazards. If you'd think twice about lending a friend £500, why would you want to lend £5,000 to a complete stranger? One answer: for a healthy rate of return that easily beats anything on offer in the savings market. In 2007, Zopa claimed an average rate of return to lenders (after fees) of 7%. In the past 12 months the average Zopa rate rose to 9.1% as consumers found it harder to get credit through mainstream channels.

And the Zopa formula appears to be working. As of December, the firm had 228,000 members, of whom about a third are lenders with 12,000 currently active. Loan disbursals are up some 140% year-on-year, and this month is set to be the biggest ever, with over £1m lent so far. Since launch, Zopa has lent out £30m. So it's still a marginal player in the overall loans market, but it's growing fast.

Is Zopa safe?

After four years, Zopa reports an overall default rate of only 0.18% (against a predicted default rate at launch of 1.6%). They claim to carry out all the same credit checks (using Equifax) as the banks, and then some turning away about half of all borrowers, including anyone with a poor credit history or without a regular income. In addition, if you lend more than £500, you are strongly encouraged to spread the risk by splitting your funds among multiple borrowers. Zopa also limits defaults by building a sense of a microfinance community, and by simply not offering bigger loans (over £15,000) to risky groups of borrowers. When defaults do occur, Zopa chases up bad debts just as banks do, and if Zopa goes bust, its collection agency is contractually obliged to continue enforcing collection.

Any negatives?

There are some investment risks to bear in mind that apply equally to similar rival sites, such as Kiva. Zopa is not a bank, it's an online marketplace, more akin to eBay or Betfair than to Barclays. So although it is regulated by the Office of Fair Trading and is a member of the Finance and Leasing Association and anti-fraud association CIFAS, it does not fall under the remit of the FSA. So none of your money is protected by the compensation scheme that bailed out Icesave depositors.

Also, compared with more traditional places to park your money cash Isas, index-linked savings certificates, government or corporate bonds Zopa is more hassle. In particular, lenders gradually find their portfolio of loans takes a bit of tending. And while your money is sitting in the market waiting to be snapped up by a borrower (perfectly possible if you pitch your offer at too high a rate of interest) it will be earning a less than appetising 0.75% below base rate. Lastly, your cash in Zopa is not currently eligible for wrapping within a Sipp, and all earnings are taxable.

So is Zopa a good idea?

Even with these caveats the rates on offer from Zopa are pretty tempting for at least some of your cash. Especially when so many supposedly 'safe' household name banks are floundering and offer very poor savings rates. And although it's a four-year old start-up, Zopa's founders and backers are all established industry players, many of them involved in the launch team at Egg. Unsecured consumer debt is a sector where banks have made huge profits. Why shouldn't lending exchanges such as Zopa muscle in on the act? Sure, you shouldn't bet the farm on Zopa, but for the feelgood factor and a decent return, it's hard to beat.