Why not try it at home? Do-it-yourself banking is a growth market

    Why not try it at home? Do-it-yourself banking is a growth market

    Turn yourself into a bank

    8 November 2014

    Hard-pressed savers in search of decent rates of return are increasingly turning to the world of ‘alternative finance’. In the first half of this year, some £500 million has poured into the peer-to-peer (P2P) loan market, which connects individual depositors and borrowers. Now a £2 billion market in the UK, it is expected to continue growing for the foreseeable future — perhaps reaching £45 billion a year by 2020, according to City brokerage Liberum.

    And its success is easy to fathom. On the demand side, personal borrowers flock to the sector to take advantage of competitive interest rates. The rates offered by Zopa and RateSetter, the two biggest P2P companies, frequently sit towards the top of the best-buy tables. Zopa will lend £7,500 over three years at 4.8 per cent APR, and RateSetter at 6.5 per cent.

    However, it’s the appetite for decent interest rates for savers (‘lenders’ in P2P parlance) that is really fuelling the sector. If they agree to tie up their money for five years, they stand to earn 6 per cent with RateSetter, or 5.2 per cent with Zopa. By comparison, the best five-year offerings from the likes of Tesco Bank pay just 3.1 per cent, according to Shorter deals are available too — RateSetter has one-month, annual and three-year accounts; Zopa has two to three-year and four to five-year options as well.

    It’s possible to earn even higher returns in the P2P space by lending to small and medium-sized businesses rather than individuals. Funding Circle works similarly to RateSetter and Zopa, and rewards the brave with an estimated gross interest rate of 7.2 per cent after fees and bad debts. The government is even getting in on the act through Vince Cable’s ‘British Business Bank’, with a pledge to make £100 million of capital available to innovators in ‘alternative finance’.

    To secure the lucrative rates of return on offer from P2P, however, depositors must accept the risks involved — of which the biggest, of course, is that borrowers may default. At RateSetter, each deposit is lent out to as many individual borrowers as the sum can accommodate: a lender can decide to split an investment of £20,000 across 10 borrowers of £2,000 each, or two at £10,000. The lender chooses who to lend to, and the investment’s performance is dependent on those individuals’ ability to pay.

    The RateSetter model is slightly riskier than Zopa’s, which spreads investor deposits across many borrowers — each £1,000 lent is divided into £10 chunks, with bigger investments split into amounts of £20. RateSetter’s current bad debt rate is 0.46 per cent compared with Zopa’s 0.25 per cent. Funding Circle, like Zopa, diversifies investors’ money across a number of borrowers but is clearly more risky, with a bad debt rate of 1.4 per cent. RateSetter and Zopa both have safeguards in place against borrower defaults, whereas Funding Circle does not. And even though its bad loan rate is higher, the way RateSetter’s ‘Provision Fund’ works actually means its lenders do better than Zopa’s.

    When a borrower defaults, the Provision Fund comes to the rescue immediately and makes good the lender’s capital and interest: RateSetter’s proud claim is that no lender has actually lost a penny in the company’s history.

    Zopa’s ‘Safeguard Fund’ by is more complicated and doesn’t cover every eventuality. Borrowers have to be in default (arrears) for a total of four months before the Safeguard Fund will compensate lenders’ capital and interest. If a borrower defaults for, say, just one month, the company takes other measures such as negotiating revised repayments or referring the case to a debt collection agency. In these scenarios, not all of the lender’s money may be returned, but Zopa is keen to point out that the way it pools lenders’ money across multiple borrowers in the first place means occasional defaults have a relatively minor impact.

    Despite these compensation funds, some lenders are put off by the absence of protection from the Financial Services Compensation Scheme (FSCS) — which guarantees to compensate savers in the event of a regulated bank or building society going bust, to the tune of £85,000 per person per institution.

    Yet RateSetter chief executive Rhydian Lewis says he’s ‘proud’ his company isn’t burdened by the costly FSCS regime. ‘Not only does the FSCS come with costs for member firms that are passed on to customers but it also has an unwelcome side effect.’ That, he explains, is moral hazard. ‘In the history of banking, there have been as many instances of bank failure after the introduction of deposit insurance schemes as there were before. They do little to prevent banks acting irresponsibly.’

    Potential investors should also remember that there is currently no tax relief on any interest earned from P2P deposits. While the Treasury has announced that P2P loans will soon become eligible for Isa investment, format and timing have yet to be decided.

    So should you trust your savings to these middlemen of the personal loan market? The rates on offer are undoubtedly attractive and the risks, while significant, are at least mitigated by the compensation funds run by the two main players in the market. Of course the middlemen exist to make a profit, and Zopa charges lenders as well as savers a fee of 1 per cent of total investment. RateSetter boss Lewis concedes that his company and its peers are easily compared to other middlemen, including ‘fat-cat’ estate agents and bankers, but he insists, ‘we’re a lot thinner’.

    Nick Hallwood, a 50-year-old product manager from Thames Ditton, started P2P lending in 2012 — using RateSetter, Zopa and Funding Circle. He says the main attractions for him included the higher rates available to investors and ‘the feelgood factor’ that ‘providing a more cost-effective source of funding for both individuals and businesses enabled people like me to have a positive impact on the economy’. He now has more than £100,000 invested with RateSetter.

    Hallwood isn’t troubled by the lack of FSCS protection: ‘I have incurred losses due to bad debt, although not out of line with my expectations. These risks were built into my original planning.’ Would he encourage others to take a punt on P2P? Absolutely, he says. ‘I’ve already encouraged friends and colleagues to look at P2P lending as another form of investment for their portfolio.’