Social Lending: A New Type of Finance?

The UK’s faltering economy and high street banks unwillingness to lend money out to almost anyone has brought a new type of borrowing to prevalence, social lending.

Social lending is an online phenomenon which has appeared in the last few years and now its potential is beginning to get noticed. Also known as peer to peer or person to person lending, it is a type of transaction which bypasses traditional financial lending institutions.

How it Works

Borrowers and lenders both visit the site and create an account. A borrower requests a loan, which can be accepted or rejected by lenders; the full amount will be raised from all of the people who have approved the loan. The idea is to minimise fees and other charges that would be levied by a bank and allow the market to set the going rate, providing a better deal for both sides.

The social networking effect   – where both lenders and borrowers can vouch for each other, rate each other and introduce new business partners – helps to ensure a low rate of non-payment and allows lenders to know exactly where the money they invested has gone.

Lenders can offer any amount from just £10 up to £25,000 or even more if they are willing to spend £380 on a consumer credit licence. Rates are set by the lender based on the perceived level of risk associated with the borrower, so it functions like a miniature version of the corporate bond market.

The service provider deals with the admin side of getting the money to the borrower and ensuring everything is protected. They will typically charge an approval fee to borrowers as well as around 1 per cent to lenders in an annual fee for providing various services including debt collection assistance and credit scoring of potential borrowers.

The Risks

Most reputable social lending platforms carry out a similar level of credit checking to most high street banks and turn away anyone with a bad credit history or without a regular income. Lending can be split between multiple borrowers to further reduce risk and in the event of a default the social lending company will chase the debt just like a bank would.

Social lending platforms are not regulated by the FSA, so money invested in one is not protected by the compensation scheme that bails out savers should their bank collapse. Any money earned through a social lending platform is taxable.

These platforms are able to bring cheap credit to consumers en masse at a time when many banks simply refuse to do this, and they open up the lucrative market for unsecured consumer debt to private investors for the first time, so it’s little wonder that market leaders Zopa have seen a 140 per cent increase in business over the past year.

Like so many of the internet’s revolutions, social lending is still very much in its infancy, but it is an innovative idea with excellent potential benefits for both consumers and investors..

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