Money Insider: Peer-to-peer lending up as rates languish

Many people were sceptical about peer-to-peer lending and questioned whether it would ever take off in the UK, but with savings rates from banks and building societies suddenly hitting rock bottom this new sector is becoming increasingly popular.

With traditional savings rates having fallen by more than a third in the last six months, returns on offer from the peer-to-peer providers are looking even more attractive.

Compared with mainstream banking, this new breed of finance is still in its formative years, with Zopa launching as the UK's first peer-to-peer marketplace in 2005.

However, a continued lack of confidence in the British banking sector, combined with high borrowing rates and poor savings returns, has seen the peer-to-peer market flourish, with more providers entering the industry in the last couple of years.

Zopa remains the biggest player and to date has arranged more than £277m in loans during the last eight years and now has over 500,000 members on its books. The average return paid to lenders in the last 12 months after any charges and defaults is an impressive 5.4 per cent.

Another major player in the peer-to-peer sector and acting as the middle man for individual savers and borrowers is RateSetter. Launched in October 2010, RateSetter may be a relative newcomer, but is growing fast. It has already matched over £57m for its lenders and borrowers, with more than £40m in the last 12 months.

RateSetter currently offers a range of lending options (for savers), paying 3 per cent fixed for a one-year bond up to 5.8 per cent fixed for a five-year income bond.

It's not surprising they're seeing a spike in business when you realise that the equivalent best-buy savings bonds from the banks are paying just 2.31 per cent and 3.05 per cent respectively.

There is even a monthly access account paying 2.6 per cent – and if you're a little nervous or unsure if this is right for you, you can dip your toe in the water and try it out with a minimum deposit of just £10.

But although the returns currently outweigh those paid by the banks, they don't offer the safety net that bank customers enjoy under the Financial Services Compensation Scheme. In short, that means while your savings are safe – up to certain levels – if your bank or building society goes bust, you will lose your cash if a peer-to-peer lender collapses.

The peer-to-peer market is not solely aimed at personal customers, and with banks tightening credit policy and reportedly extra cautious about lending to small and medium-sized enterprises a new breed of business lenders has emerged to fill the gap, including Funding Circle.

Funding Circle has lent more than £80m to businesses since its launch in 2010, with the average loan at around £40,000. It pools the savings of investors, who have averaged returns higher than 8.8 per cent, while the current bad debt total is around 1.5 per cent.

Consumers shouldn't see this alternative banking concept as a soft touch, as a strict credit-scoring regime is absolutely vital to ensure defaults are kept to a minimum in order to give people confidence to continue to deposit their savings with the peer-to-peer companies.

RateSetter, for example, last year reported that less than 15 per cent of loan applications were approved, so while it may offer a simpler and fairer way to borrow money, if you don't have an excellent credit profile you're going to have to seek your finance elsewhere.

For lenders, even though the tough credit-scoring criteria is in place, there is still that element of risk, albeit small, that you don't have with a bank or building society because of the lack of protection for your cash through the Financial Services Compensation Scheme. But as long as you understand and are comfortable with that, you can get better returns on your cash in the peer-to-peer market.

Providers have their own methods of trying to reduce the risk to depositors. Zopa for example will spread your money among a wide range of borrowers, while RateSetter adopts a different approach by operating a "provision fund" which is built up from borrower fees, and reimburses lenders in the case of late payment or default.

The more established the market becomes, the more confidence consumers will have, and if providers continue to keep rates competitive and bad debt levels at current low levels, the peer-to-peer industry will remain a growth area and become more widely accepted as a credible alternative to the banks.

Andrew Hagger is an independent personal finance analyst from moneycomms.co.uk