I have been investing in social lending in the UK now for approximately two years and found it a very rewarding process, both financially and personally. On a regular basis I have discussed this relatively new area of investing with others and so wanted to share on a wider scale my personal experiences with the process and provide some background information in what social lending is, and is not, which I hope will help others.
So the focus of this series of articles is for those perhaps just starting out in social lending or considering it as an investment vehicle. For those well down the path I hope they will provide comments on their own experiences and so help others too. Although the focus will be on the UK market, I trust some of the issues and concepts covered will be of use to readers from other jurisdictions.
So what is social lending? Also often referred to as peer-to-peer lending (P2P), social lending provides the public with access to the unsecured private, and on some sites commercial, small loan debt markets that have otherwise normally been serviced by banks, finance companies and other financial institutions. Starting from as little as £10 a saver can deposit money with a social lending site and have this money then loaned out to borrowers. Although with £10 you are only going to be lending to one borrower, the idea is that with more substantial investment deposits the default risk is spread over a number of borrowers and over a range of risk categories and time periods. The social lending site acts as an intermediary and deals with the forming of contracts, exchange of funds, repayment of monies and the chasing of late payments and defaults. And for this service a site takes a small fee from both borrowers and lenders.
Now each social lending site approaches this process in a slightly different way and so we will provide a brief overview of each, in the UK market, to give you a feel of how they go about this and the differences in their approach to this relatively new but exciting form of investing.
Zopa (Zone Of Potential Agreement) was launched in March in 2005 and is the largest of the three main providers in the UK with over £160 million now being lent.
Zopa looks at the credit scores of prospective borrowers, and gives them a rating based on their level of risk. The ratings are A*, A, B, C or (Y)oung. Lenders can then decide where that money is lent. So if you wish to minimise your risk you can confine your lending solely to A* borrowers. Or if you have a higher risk tolerance and so wish to achieve a higher return you can lend solely at the C and Young borrower levels. Most lenders seem to take a balanced approach and have a range of risk categories in their loans books. Loans on Zopa can be either 36 or 60 months with interest rates of course being higher on the five year market. For the privilege of lending through the Zopa site you will be charged 1 percentage point of money on loan. So, if you are lending at an average of 7%, Zopa’s 1% will bring you down to 6% of which you then have to pay the tax.
Zopa now also has a facility whereby you can sell part of your loan book, for a small fee, back to Zopa who then re-lend back to those lenders prepared to accept, as they call them, Rapid Return loans. The requirement is that the loans you wish to sell must have had no missed payments. This prevents you off loading problem loans and protects the integrity of the secondary market.
The second largest site in the UK is Funding Circle, having now lent over £26.6 million. Rather than lending to individuals, as Zopa does, Funding Circle provides a market for small businesses. Funding Circle has a team of underwriters who review each loan application and only allow businesses established for more than two years, and with a good credit score and financial position to be presented to lenders.
Funding Circle takes a similar approach so Zopa by undertaking a risk assessment of each borrower assigning them to a category of least risk at A+ (referred to as “very low risk”) through to a higher risk in category C (referred to as “average risk”). Again, Funding Circle manages the movement of funds, repayment of monies and the chasing of late payments and defaults.
Funding Circle offers a slightly different secondary market for loans whereby you can sell your loans directly to other lenders, of which Funding Circle takes a small fee (0.25%). You can set your own sale price (at a discount or premium to face value, within set limits) and so determine how quickly it is picked up. This is an area I am quite active in and keeping an eye on what others are selling provides another a means of picking up loan parts often at good interest rates.
Your money can be lent out through an automated setting, called Autobid, where you set the different rates you wish to charge at the different risk categories. Or you can review each business loan offer and make your bid manually. I tend to use both approaches.
Funding Circle will charge you, like Zopa, a 1 percentage point fee based on your total funds loaned.
The smallest of the major sites in the UK is RateSetter. Although having now lent over £17.8 million RateSetter is an excellent alternative providing investors with the opportunity to lend across a monthly, one year, three year or five year basis. The one month rolling market tends to generate a rate of approximately 4% with the five year rate sitting around 7.5%.
A major difference to both Zopa and Funding Circle is how RateSetter covers the default risk. Whereas the former two sites provide you with the service of chasing defaulting borrowers, if unsuccessful, you still lose your outstanding funds. However RateSetter provides additional protection through their Provision Fund facility. This fund, built up through part of a borrower’s initial fees, provides set aside funds so that when monies cannot be reclaimed from the borrower RateSetter should (although not guaranteed) reimburse the lender for loss of capital and, if sufficient funds, interest as well.
RateSetter is also different in how it charges you as a lender. Instead of the 1 percentage point of funds outstanding, it charges you 10% of interest earned; the difference is subtle, but important. So in the above examples instead of you earning 6% from your initial 7%, you would earn 6.3% at RateSetter.
Over the next few articles I will go into some greater detail about each of the sites and what I have found works, and how each has been performing for me. I will also touch on the new peer 2 peer finance association, the difference between saving in a bank account and investing in social lending and provide additional web resources where you can find more information.