Peer-to-Peer Lending Do Zopa, Ratesetter & Funding Circle really pay 8% on savings?

You can earn a massive 8% interest on your cash. The catch? These aren't Govt-protected savings accounts, they're new 'peer-to-peer lending' sites where income is generated from lending to others, involving some RISK.

This is a guide to earning higher rates using companies like Zopa, Ratesetter and Funding Circle. We ask: are they any good? What's the risk? And who are they right for?

This is the first incarnation of this guide. Please feed back on if it worked for you, if you have experiences with peer-to-peer lending, and if there's anything you think needs adding.

What is peer-to-peer lending?

Peer-to-peer lending takes the age-old process of loaning cash to friends in return for a bit of interest, and expands it to an industrial scale. Websites like Zopa, Ratesetter and Funding Circle unite lenders (savers hunting for a good return) and borrowers (individuals or companies).

How much you lend, and who you lend to, remains totally your choice, as is how much you want in return for doing so. The interest you earn comes from the rate paid by borrowers, minus the fees charged by the peer-to-peer websites.

The sites sort contracts and the administrative bean-counting (such as collecting money owed) in return for fees, usually from the lender AND borrower. But unlike banks there's NO guarantee to ensure you get the money back, though the sites all use techniques they say help achieve this.

Peer-to-peer sites have pretty good systems to check borrowers can repay your cash – and history so far has shown these to work – and facilities to chase repayments on your behalf should a borrower fall behind. So while it's not 100% guaranteed, the process requires far less of your own legwork than lending a tenner to "that fella down the pub".

Earn DOUBLE top savings rates

It's no coincidence the boom in popularity has occurred while standard top savings rates are so low. Peer-to-peer sites have no FCA-regulation costs, and are online only - a low-cost model.

This allows fees to be relatively low, so savers achieve almost the rates paid by the borrowers. Banks effectively use the same model, though modern banking uses the money markets much more – but their costs are much higher, which slashes the savings rates they can offer.

'Normal' savings vs peer-to-peer (best pre-tax rates at 26 Nov 2012)
	Easy access	3-year fix	5-year fix
Normal savings	2.4%	3.3%	3.5%
Peer-to-peer websites	2.9% (1)	8.1% (2)	8.4% (2)
(1) via Ratesetter (2) via Funding Circle, risk level 'A'

Who am I lending to – how likely are they to pay me back?

The biggest risk here is that the folks you lend the cash to simply don't pay up. The past performance of the three big players has shown it isn't a big problem, but as the old clichéd-but-accurate regulatory statement shows, the past can't predict the future.

While they're NOT a guarantee, the main sites use various methods to try to ensure loans are repaid.

• Spreading the risk
  This builds on the old adage, "Don't put all your eggs in one basket". Just like financial advisers suggest splitting investments between different types and risks, some peer-to-peer sites automatically slice your savings down into small chunks and lend those out, rather than the whole lump.
  
  So if one borrower doesn't stump up, the hit on your stash isn't catastrophic – it should just bump down your rate a bit. You can bolster this yourself by lending in different markets (they grade borrowers by credit score), or using multiple peer-to-peer sites.
• Credit scoring
  Anyone who wants to borrow money gets credit scored, just like when applying for a bank loan, credit card or mortgage (see the Credit Rating guide for how this works).
  
  Most sites then split borrowers into tranches, labelled according to their score (eg, A to C) – the lower the score is, the higher rate you get. These can be pretty draconian – Ratesetter, for instance, says it only accepts 12% of loan applications.
  
  If companies are borrowing, the fraud agency CIFAS is contacted for information on whether they have been involved in fraud.
• Bail-out fund
  One site, Ratesetter, has come up with the Provision Fund. Money is filtered into here from borrowers' fees so it gradually builds up as a safety net. Then if someone doesn't repay, the saver's compensated (incl interest owed) from this central fund.
  
  This is all Ratesetter's doing, so if the fund wasn't big enough (based on current 'bad loan' rates, it seems fine) you've no comeback. Effectively, it means all lenders get their money back barring a catastrophe, rather than some doing well, and a few suffering.

Tips to protect yourself

The three big players publish their own stats into how many loans turn 'bad', ie, aren't repaid by borrowers. At the time of writing, the average percentage was 0.1% to 2%, depending on...

• The company you choose to lend through, eg, Zopa.
• The group of people or businesses you choose to lend to – they are categorised by how risky they are, and this is totally up to you.

This underlines that while peer-to-peer is a good use of cash for many people who are sophisticated enough to know and understand the risk they are taking, it's certainly not right for anyone who wants cast-iron certainty of return or safety.

You need to factor in the likelihood of bad debt into your expected returns. One contributor to the forum got a pre-tax return of 7.4% per annum from lending, but estimates this would have been 9% if all borrowers had repaid their debts.

Also, be wary of putting all of your assets in peer-to-peer - everyone with sizeable cash should use simpler savings accounts and cash ISAs too. Use high-rate regular savings as well, but there's a limit to how much you can save each month.

If you want to dump a big amount in peer-to-peer lending sites, then combine the three together so not all your cash is in one place.

On top of this, you should consider balancing out lending to high risk (and therefore high rate) borrowers – who are more likely to be 'bad debts' – with lending some cash to 'safer', lower rate prospects too.

Best buys: Which sites pay the most?

There's a clear big three, though the market's developing fast, suggesting more will pop up soon. The choice is really between which of their features most suits what you are looking for - we've listed them below in alphabetical order.

You MUST know the risks - peer-to-peer lending isn't for everyone

The first £85,000 saved per person, per financial institution in a 'normal' savings account – those offered by banks and building societies – is 100% guaranteed by the Government-backed Financial Services Compensation if your bank went bust. The exact rules get a bit fiddly – see the Savings Safety guide - but this is about as strong as guarantees get.

Conversely, with peer-to-peer lending, you could lose the cash you lend. However, past performance of the three big players has shown that hasn't happened yet – but just like in the investment world, what has happened in the past doesn't mean the same will happen in future.

Nevertheless, it's crucial to understand the key potential risks…

• The borrowers you lend to don't pay up.
  You need go in with your eyes open. If the people or companies you lend to don't pay back the money lent out, there's no legal scheme to bail you out.
  
  However, the peer-to-peer websites take measures they believe will mitigate the risk, such as setting up a bail-out fund (not Government-backed) or splitting the money you lend between multiple borrowers to spread the risk.
  
  We aren't here to say the money you're lending won't be paid back, simply that it could happen, and no one would bail you out if it did (with the exception of the Ratesetter fund – if it has enough cash to cover it).
• What if one of the peer-to-peer sites went bust?
  Peer-to-peer sites will briefly hold your cash themselves – primarily while you are waiting to be matched with borrowers who are willing to pay the interest rate you're after (you earn no interest in the meantime).
  
  In these circumstances, all three sites keep the dough in accounts that are ringfenced - kept separate from their own money. This means if the site were to go bust, your money should remain untouched (though of course this is untested, though this 'escrow' concept is quite common in other fields).
  
  Check the bank it uses to hold this cash and whether you keep other money in the same institution – we've noted this in each best buy peer-to-peer site. If you do, ensure the total doesn't exceed £85,000, as it'll top the limit set for UK FSCS protection. The risk is slight, but make yourself aware – see the Savings Safety guide.
  
  The big three peer-to-peer sites have set up the Peer-to-Peer Finance Association. Members must ringfence savers' money, have a solid capital base and a contingency repayment plan if it goes bust – where administrators would prioritise repayments of unlent cash and collecting debts.
• The unknown unknowns
  This is a relatively new industry with an innovative model, so while we haven't been able to dig up horror stories or glaring problems, there's no real regulation or legal protection. Anyone using peer-to-peer lending must be aware 'unknown unknowns' could crop up at any time, potentially blighting cash in a way no one could predict.
  
  This makes it important to spread your cash around different types of savings and providers, so you aren't overexposed to any unpredictable shocks.