Peer-to-peer loans: Can you get better returns by lending your cash to others?

When peer-to-peer lenders arrived in the UK a few years ago, I was terribly wary of them. They offered the opportunity for me – and you – to lend our money to other people.

But why would we want to? Lending money to anyone is risky. And who wants that risk? Then there was the fact that we could stick our money into a decent deposit account which offered security as well as decent returns. But, of course, the latter is no longer true and hasn't been for years, with interest rates at an all-time low.

So with hard-pressed savers lucky to get as much as 2 per cent interest on their cash in a bank or building society, the higher returns available from peer-to-peer lending have become much more attractive.

It's easy to be confused about what the firms offer, but it's simple. They take your cash and lend it to others in return for a small fee. With no big banks involved, savers can get higher returns and borrowers lower rates. And as the industry has matured it's become mainstream.

This week that fact was recognised by the Banking Commission. In its long-awaited report on banks it said: "Peer-to-peer and crowdfunding platforms have the potential to improve the UK retail banking market as both a source of competition to mainstream banks as well as an alternative to them."

David Black, banking specialist at Consumer Intelligence, says: "The peer-to-peer platforms are offering a real alternative to the established banks. While there are other factors to be taken into account, they are offering higher rates to savers than are available from bank or building society savings accounts."

The biggest is Zopa, which matches savers with individual borrowers. It has lent £320m to UK consumers, lending £107m in the last year. "We're spearheading the consumer choice that bypasses the banks and provides a higher reward for being good with money," says boss Giles Andrews.

Meanwhile, Funding Circle – which launched in 2010 to put savers in touch with small firms looking to borrow – has recently passed the £100m lent milestone and says it's on course to reach another £100m in the next year.

Co-founder James Meekings says: "Our growth demonstrates that peer-to-peer lending is challenging the way business finance is done with an army of British people helping to fill the gap by lending directly to ambitious businesses."

They're fine words from folk keen to promote their businesses, but should you really be considering peer-to-peer lenders as an alternative home for your savings? What about the risk, essentially, that people or companies borrowing your money don't pay it back?

"For savers it's important to understand there is no cast-iron guarantee as you get with bank or building society accounts under the Financial Services Compensation Scheme," points out Andrew Hagger of our Money Insider column.

The compensation scheme means that in the unlikely event of your bank going bust your savings would be protected, at least £85,000 of them. With the peer-to-peer lenders the scheme does not apply, so your cash is at risk.

However, some of the main peer-to-peer companies have introduced their own safety net to reassure savers. RateSetter – which has lent more than £74m to individuals – uses a provision fund to shield lenders from bad debt. Currently it has a balance of just over £1m which, according to the firm, is enough to cover its actual bad debts experienced so far six times over.

Meanwhile Zopa has a "safeguard" feature, which offers similar reassurance to worried savers.

Even without that, default levels – where people or businesses fail to repay loans – are low. With Zopa the default level is 0.76 per cent while RateSetter quotes 0.35 per cent. Also, you can spread the risk by sprinkling your savings around different borrowers. The deals are done online, so it's fairly easy.

Given all that, are the returns you can get that much better? "In this era of low interest rates, the peer-to-peer platforms are offering higher rates to savers," says David Black. For instance, while the best three-year, fixed-rate account was 2 .55 per cent with ICICI Bank, at Zopa you could get 4.3 per cent.

Mr Hagger has turned to peer-to-peer himself. "A Tesco Bank fixed-rate bond matured in May, but when I came to renew, the best one-year, fixed-rate bond rates on the market were just 2 per cent. I put my funds with RateSetter for 12 months and got a rate of 3.1 per cent."

So peer-to-peer lenders can offer better deals, for borrowers as well as savers, incidentally. But should you use them? Only if you are comfortable with using their online sites.