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Peer-to-peer lending has burst onto the UK’s financial scene in the last few years, making headlines in all of the major financial papers and websites. Originally only a form of lending between businesses, peer-to-peer lending has now become a popular way of borrowing in the consumer market.

But what is it? And what does peer-to-peer (p2p) lending have to offer the ordinary British borrower?

Peer-to-peer lending and borrowing

Peer-to-Peer Lenders

Online peer-to-peer websites have been around for the best part of a decade. They bring together borrowers and lenders and so cut out the high street bank and other mainstream financial organisations. The principle behind this form of lending is to offer better rates to both parties: lenders and borrowers. Most of the major peer-to-peer lending sites (e.g. Zopa and RateSetter) offer better interest rates to those prepared to lend money than they would get in a savings account at the bank (and even the typical cash ISA). Borrowers, meanwhile, get access to lower interest rates than they would if taking out a personal loan with their bank.

Before you jump in and put your own money up for lending with one of these sites there is an important catch: none of them are covered by the Financial Services Compensation Scheme which protects savers who have up to £75,000 on deposit. Should the borrower fail to repay your money then, if normal recovery methods fail, you won’t be able to guarantee getting your money back.

That is why the p2p sites are able to offer higher rates than savings accounts. While they do say that they carry out credit checks on borrowers and will handle debt recovery if something goes wrong, there is little more in the way of a guarantee should the worst happen.

Some of these sites do have capital reserves which are there to make good any losses incurred by individual lenders.

Things to watch out for

While p2p lending has been growing rapidly, it’s fair to say that it has just as many critics as it does cheerleaders. The former chairman of the Financial Services Authority, Lord Turner, recently said that savers were taking huge risks using these to make interest rather than opting for more traditional forms of saving.

He added: “The losses which will emerge from peer-to-peer lending over the next five to 10 years will make the bankers look like lending geniuses. The key to peer-to-peer lending is to accept that your money will be lent out and you might not get it back.

He also expressed doubts that p2p websites were conducting thorough enough credit checks on applicants for loans and that little assessment was being made of people’s ability to repay the amounts that they borrow.

But Martin Lewis, the founder of moneysavingexpert.com, said that the returns for savers were good and that, although there was no guarantee that you would get your money back, most borrowers were proving to be responsible.

How do the sites work for borrowers?

Peer-to-peer lending websites usually levy a fee on borrowers to cover their costs. This is on top of the interest that is charged on the loan which goes to the lenders (minus, usually, a commission for the website in question).

Borrowers don’t have to pay the fee up front – it is added to the loan amount upon approval – so if you are considering applying for a loan through one of these sites, it’s important that you understand exactly what you’ll be paying in fees as well as the APR on the loan itself. While the initial interest rate can seem attractive, these fees can push up the total amount that you have to repay considerably if you are only looking to borrow a small amount.

A typical interest rate for a peer-to-peer consumer loan is around 9% with an administration fee of £180. That means that if you borrowed £7,500 with a repayment schedule of five years, you would repay about £160 a month and be looking at total interest payments of close to £1,800.

With interest rates at record lows, an individual borrower might find a lower personal loan rate at his or her bank or from an online lender. That will depend, of course, upon the borrower’s credit rating and individual circumstances which could make the cost of a loan considerably more expensive.

While peer-to-peer lending has garnered a lot of headlines recently, the rule for consumers is the same as it has always been – don’t necessarily believe the hype and always shop around for the best deal for your circumstances. It may well be that a traditional or bad credit loan might make more financial sense than a peer-to-peer loan.