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Social Lending Seems Like A Good Option, But Is It

by Jim ONeil on June 1, 2011

in peer to peer lending

Anyone who saves money looks for the best places to put it. People want their hard-earned cash to work for them but with interest rates so low, this is easier said than done. Social lending sites tempt savers with returns that exceed those offered by banks.

Though they seem to represent an alternative to investing, many people are unsure of whether to trust these sites. Social lending has several benefits and drawbacks that a potential lender should be aware of before turning over any cash.

Social lending, also referred to as peer to peer lending, was formally established in the UK with the launch of the first social lending Web site in 2005. The lending process matches individuals in need of money with others who are willing to lend the funds in exchange for a decent interest rate.

The loan costs less for a borrower than one from a high street institution and a lender receives a better return than is offered by a bank.

A social lending site does not directly hold the money provided by a lender. Instead, the funds are lent to borrowers at pre-established prices. Borrowers repay funds to the social lending site, which passes the funds to the lenders.

Social lending models are primarily rating or auction based. With the rating based model, the borrower applies for the loan directly on the social lending site. The site issues a rating to the individual based on credit history and then searches for willing lenders offering a competitive interest rate.

Borrowers in an auction based model advertise how much money they need and the desired repayment term. Different lenders place bids to fund a portion of the loan. Once the bids are sufficient to fund the loan, the site selects the lenders offering the lowest interest rate and establishes the loan agreement.

When this method is used, borrowers can explain why the loan is needed and what they want to pay and each lender can determine interest rate independently of the others.

From a lender perspective, one of the best things about social lending is the ability to earn a significantly higher return than is provided by a bank savings account. If a borrower is high-risk, lenders can often charge the person a higher interest rate.

However, these additional profits come with a higher chance that that the person will default on repayment. Another positive aspect of social lending is that lenders are helping individuals or small businesses who really need a loan, not simply providing a bank with extra cash.

Borrowers like social lending because it often enables them to get financing at a lower interest rate than a bank offers. This is particularly true when they are interested in borrowing a smaller amount of money over a shorter time.

Individuals with poor credit can find much less expensive funding through social lending than by using payday loans. Social lenders are often more forgiving than banks, considering a borrower-submitted explanation of why the credit rating is poor and why the money is needed. Early repayment is also permitted and does not carry a penalty charge.

With these positives come several negatives. For lenders, a primary drawback is the higher risk of using the money for social lending than keeping it in a savings account. Experts equate the level of risk to that of investing the money in stocks.

If a borrower defaults on a loan repayment, the lender may never see that money. Lenders can control the risk somewhat by lending only to borrowers with a good rating.

In addition, the funding is usually split to fund loans to different borrowers. If one borrower defaults, only a small portion of the investment will be lost, mitigating risk. Many social lending sites also have a collections staff that attempts to recoup outstanding payments from borrowers.

However, if they cannot obtain repayment, the money may be lost. The UK deposit protection program does not cover social lending sites. Therefore, if a borrower defaults or the lending site itself goes defunct, there is no government guarantee that money will be repaid.

Most sites keep lender funds in a separate account that theoretically should protect the money if the site folds. However, this money does not accrue interest. Once funds are lent to borrowers, the lender has little protection.

The FSA is not charged with regulating social lending Web sites. Therefore, no common standards have been established for the industry and there is no consistent procedure for complaints. Lenders cannot refer complaints to the financial ombudsman if they are unable to recoup their money from the lending site company.

Another drawback for lenders is that once they have agreed to loans and transferred funds to borrowers, they are locked in for the duration of these loans. If they end up needing the cash, this money may be unavailable until the loan ends or there may be a penalty for early withdrawal.

Lenders should ensure that they will not need the cash before they commit it to a loan.

Borrowers also face drawbacks similar to those of a bank loan. Monthly repayments must be made on time and the loan must be repaid in full. If repayment is not made, credit will be damaged, collections actions may be taken, and the borrower may land in court.

Borrowers also may pay an underwriters fee in addition to regular interest. This fee is usually over £100 and is designed to cover costs for the Web site, finding lenders, and drafting the loan agreement. Lenders also pay a fee of about one percent of the loan to the lending site.

Rate-Setter, Funding Circle, Yes-Secure, Quakle, and Zopa are the main social lending sites in the UK. While social lending offers a more attractive return to lenders than a bank, individuals should consider the added risk before deciding to serve as a social lender.

Those who have an assortment of investments and do not consider the inherent risk a deterrent may find social lending financially attractive.

UPDATE SEPTEMBER 2011

UK Social Lending Sector Becoming Self-Regulated

The largest peer-to-peer lending networks in the UK are banding together to request regulation of their emerging marketplace. This move is largely due to the fear that less reputable operators may place consumer money in jeopardy.

Three of the largest lenders have created a structure of self-regulation that they hope regulators will use as a sample framework.

Founders of Funding Circle, RateSetter, and Zopa created the self-regulation “blueprint” for potential regulators. They fear that growth in the social lending market will draw poorly managed or unscrupulous lenders that could tarnish the yet-to-be-established image of this expanding sector.

Giles Andrews, Zopa founder, stated that of the new entrants over the past year, several show a lack of consideration for risk.

Sites like Zopa have obtained a consumer credit license from the Office of Fair Trading, providing borrowers with limited protection. However, a social lending operator is not required to apply for this license. In addition, the rules do not directly apply to the loans, offering no protection to lenders.

Operating principles that include minimum capital requirements have been established by the Peer-to-Peer Finance Association.

This year alone, peer-to-peer lending will be responsible for over £100 million in individual and small business loans. Consumers who do not qualify for traditional financing often find these loans cheapest of all available. Far from being a burden, social lenders view regulation as necessary.

Many aspects of the regulatory blueprint have been taken from other industries subject to Financial Services Authority (FSA) regulation.

Since last year, Mr. Andrews has lobbied the government and FSA for regulation of his industry. He said his actions are not protectionist. He wants new lenders because they will grow the sector more quickly than they will consume market share.

Savings interest rates are likely to remain low during coming months, providing investors with additional incentive to enter the peer-to-peer market.

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