Lending cash to others can mean higher rates

Investors struggling to find decent interest rates are being targeted by a new "social lender" offering returns of between six and nine per cent. The Funding Circle hopes to emulate the success of Zopa, which is the most well-known social lender in the UK. In fact there's already a new company on the social lending block as Yes-Secure launched its business last month as an alternative to Zopa. But the new company, which is launching this summer, promises something different.

What is social lending? See the box right for a full explanation but, in short, it's when investors lend money for a return on top of their initial investment. Zopa and its rivals effectively act as online exchanges to marry up investors who stump up the cash with borrowers who need a loan. While the Funding Circle will follow a similar model to that of the already-established businesses it won't be lending to individuals.

Instead, it will lend to established businesses – both limited companies and sole traders. Businesses will be able to borrow between £5 and £50,000 and investors can lend anything between £20 and £2,000 per business – although it is recommended that investors spread their risk across as many businesses as possible.

The company is expecting considerable interest from both investors and borrowers as high-street cash spreads are very wide. Savers are finding it difficult to secure decent interest rates, while business borrowers face steep interest rates to gain business loans.

James Meekings, co-founder of the Funding Circle, said that the final part of the technology for the online systems is still being built, with a view to launching later in the summer.

He explained: "We think it is an exciting way of getting a financial return with returns around six to nine per cent and, if you look at business lending as a market, bank rates range from six to 18 per cent for unsecured loans. There will be a lot [of banks] watching this market.

"Our research shows that people really want to support small businesses in the UK as they represent an important part of the economy." Meekings says that investors should consider social lending to businesses as being "on a par" with corporate bonds in terms of risk, but stresses that social lending is very much an asset class in its own right.

Those in any doubt about the quality of borrower that the business may attract should look at the tight parameters set out by the Funding Circle. The company has no desire to attract businesses looking for start-up funding and its credit scoring process is, it seems, just as strict as its successful industry peer Zopa.

Meekings explains: "We only want high credit quality business and we make that absolutely clear. Defaults will be very much in line with Zopa levels. We have strict minimum criteria for borrowing.

"We then screen the business so only a small proportion of applicants will get on to the platform. The process of that is very similar to personal lending but we will have information on the income of a business, too. The smaller a business, the more scoring goes on the directors of that business so when the business information gets thinner it becomes more about personal lending."

Investors considering using the service are also likely to take some reassurance from some of the individuals on the board of the Funding Circle, as there is a strong pedigree in financial services.

The company's chairman is Laurie Edmans CBE, non-executive director of the Pensions Regulator, board member of the National Employment Savings Trust (NEST) and the former deputy chief executive of life insurer NPI. Edmans is flanked by a former financial services lead at management consulting firm McKinsey and an ex-equities chief at Goldman Sachs.

News of this forthcoming launch comes after the success of Zopa and the recently launched personal lender Yes-Secure, which follows a similar model. When Zopa launched, UK investors were sceptical about the level of defaults that could be expected and the likelihood of a decent-sized return, but those that took the plunge have so far done rather well.

Zopa lends to individuals as opposed to businesses and launched in March 2005 but, despite the huge economic downturn and the impact that had on individuals, it still boasts a default rate of 0.7 per cent since launch. It has a choice of borrowers, labelled from A* (ultra-clean credit rating) down to C (prime borrower, but with a more complex past). Zopa rates borrowers by overlaying its own criteria over an Equifax credit file.

As well as taking traditional credit scoring into account, Zopa also looks at "lifestyle" indicators such as whether the level of unsecured debt is increasing or decreasing and not just the repayment record in isolation.

The model has supported the business as it has grown with the default rate remaining steady despite facilitating loans of £36m in 2009 and targeting £60m for 2010. More impressive, perhaps, is the average return to investors that stands at 8.2 per cent for the past 12 months and 8 per cent since launch.

Giles Andrews, co-founder and chief executive of Zopa admits there is no generic answer to the level of defaults that can be expected from a peer-to-peer lender but says that there are several factors investors should consider.

"There is nothing in the model that can give you a definitive default number as it depends on the type of borrowers you are attracting and the type of borrowers being approved. But we have always been quite conservative on who we allow our investors to lend to. We have very strict security and credit vetting."

In the UK, the story of social lending has been broadly positive with most investors happy with the level of return they have witnessed, but this has not been the case worldwide. At around the time that Zopa launched in 2005, a similar business was being established in the US. "Prosper" decided to target the now infamous sub-prime market and the business was left dealing with far greater defaults than could possibly have been imagined.

Andrew's says his business had considered that route and were lucky that they opted for the "prime" market, given recent circumstances. "We knew that the UK consumer, even in 2005, was over-indebted with too much unsecured, credit-card-type debt," he says. "So we took greater notice of their existing unsecured debt balances and were worried about the potential affordability issue of a new loan."

Andrews stresses that new investors must remember the key to social lending is keeping the spread of borrowers as large as possible. While Zopa says the minimum investment is £10, Andrews says that investors are recommended to lend at least £1,000 in order to be "pretty well diversified" and £2,000 to be "very well diversified". While the default rates are relatively low, increasing your initial stake may be worthwhile for the additional peace of mind. Naturally, investors also have the choice of where they choose to lend.

What is social lending?

Social lending – also known as peer-to-peer lending – is where individuals lend their money to others for a financial incentive. Effectively, the people who put their money up – the investors – are acting in place of a bank. Investors are attracted by potentially higher returns than they could get on a deposit account, although there is a risk that they may not be repaid.

Borrowers are attracted because they may have a better chance of securing a loan, which may not be agreed through the high street banks' normal rigid lending strategy.

Social lending not a new phenomenon, but it has been transformed by the internet from what was traditionally a very small market into a multi-million pound business. These days, large sums of money changes hands between individuals through online exchanges such as Zopa.

Investors that stump up the cash can invest as little as £10 in return for interest varying from 6 per cent to 15 per cent. Rates are set according to individual cases and the perceived lending risk.

Expert investors suggest that a minimum of £1,000 is invested, however, so the investment can be divided up between many individuals (or companies). This spreads the risk so that if there is a problem with one borrower, investors won't lose all their cash.

The danger from investors' point of view is the risk of defaults, where borrowers do not repay the loan or do not pay it back in full. However, with borrowers having to persuade people to lend them the money, the default rate tends to be less than with normal lending.