Is peer-to-peer lending worth the risk?

I'm thinking of borrowing through a peer-to-peer site. Is it worth the risk?

Peer-to-peer or social lending is a relatively new way to lend and borrow money online.

The principle is simple: the sites hook up those with money (investors) with those without (borrowers) in return for a fee.

But what if the borrowers don't pay? Or the investors raise their interest rates?

We'll take a look at how the market works and ask: is it worth the risk?

Why peer-to-peer lending?

The idea of peer-to-peer lending was pioneered by Zopa (short for 'zone of possible agreement').

The site launched in 2005 and, as of September 2011, members have lent each other £150 million.

Zopa remains the market leader but - with around 30 similar companies in the marketplace, including Yes-secure and Ratesetter - their rates have become increasingly competitive.

With peer-to-peer lending, investors are able to get a better return on money than they would otherwise enjoy with a mainstream savings account.

A typical site offers investors up to 8.3% APR over three years. And interest can be as high as 14%.

Borrowers, meanwhile, can often obtain credit at a lower rate than they could from a bank. Loans generally go up to £15,000.

What are the risks for investors?

The higher rates of interest that investors can enjoy through social lending aren't risk-free.

Peer-to-peer websites aren't yet regulated by the Financial Services Compensation Scheme (FSCS) which covers most UK savings accounts up to £85,000 invested in one institution in the event of a bank or building society going bust.

Find out more about FSCS in our full savings protection guide.

Peer-to-peer lenders also do not guarantee a return on invested money.

Nevertheless, defaults on social lending are very small so far.

In 2010, Zopa's average default rate was 0.7% and Yes-secure's and Ratesetter's was 0%.

However, loans are split between multiple borrowers to diversify the risk of payment default.

Lenders may also lose potential interest if a borrower chooses to repay their loan early.

The costs

Reaping the rewards of accumulating interest payments also comes with a price.

Zopa charges investors 1% of the total amount lent, while Ratesetter charges 10% of the interest received by investors.

Yes-secure charges a fee of 0.9% of the amount lent.

What are the risks for borrowers?

Currently, one of the biggest risks for those looking to borrow is not having an application accepted.

Different P2P sites have different requirements:

• Ratesetter - Is one of the more stringent sites, it only lends money to the prime borrower market. It isn't a good choice for those with a history of credit problems and only approves 12% of applicants. For this reason, it has not yet suffered a default.
• Zopa - Requires that borrowers go through a full underwriting process and will be told the rate at which they can borrow money. Approximately 50% of applicants are rejected.
• Yes-secure - is, according to its site, "a little less strict about who it lends to than Zopa".

However, a major benefit to making a peer-to-peer lending application is that when the site checks credit reports it does so not with a full credit search but with a quotation, or soft, search.

Quotation searches don't show up on credit records.

Full credit searches do and can damage the creditworthiness of those making loan applications, since lenders prefer not to accept applications where it looks like the borrower is taking on a lot of borrowing.

The cost

The obvious cost is the amount of interest and fees.

Just as in the mainstream, peer-to-peer lenders offer interest rates dependent on credit worthiness.

Rates can vary between 6.8% and 20% and social lenders are, by no means, always cheaper than banks.

Sites may also charge one-off fees:

• Zopa charge a £130 fee for approved loans
• Yes-secure charges an arrangement fee of £80 on any approved loan
• Ratesetter charges a 'credit rate fee' for borrowers taking out a variable rate 'rolling loan' with minimum monthly repayments. This fee is typically £50. Ratesetter also charge a £50 'borrower fee'.

What if a site goes bust?

Another obvious risk is a peer-to-peer lending site going bust.

As we've already discussed above, site's investors aren't covered by the FSA's compensation scheme.

Social lending sites do make their own arrangements to protect customers should they go out of business, however.

The contracts made between borrowers and lenders are legally binding and stand apart from the sites. Therefore, even without the sites involvement, lenders could continue to receive repayment and borrowers would be obligated to continue to repay their investment, at the rates agreed at the beginning of their association.