Introduction to social lending Part 1 – Start growing your money
The banks hate us. We know this to be true. We paid for their mistakes during the bailouts and we still continue to suffer for their sins today. They screwed up and now they’re stealing from us to bolster their balance sheets. And good for them; it’s good business! Maybe I’m being a bit dramatic when I call it stealing. I don’t believe that letting someone take what is yours can be classified as theft. They take from us in a number of ways but one of the most obvious ones is when we allow our money to sit in savings accounts with paltry interest rates while the banks lend out our deposits to the British public at exorbitant rates. They effectively make a ton of money from your cash while your wealth decreases, in real terms, due to the effect of inflation.
Let me be clear about this though. I think the banks’ behaviour is appalling, but if you’re leaving your money in a savings account that’s making 2% or worse, I think you deserve everything you get. If you want to achieve financial independence, acquiring assets is key. Putting your money in places where it will continue to grow is important. So why are so many of us not doing that? I think a lot of us lack education and risk tolerance when it comes to assets such as shares and bonds. Maybe we can’t see any better alternatives to watching our money slowly wither away in one of these awful savings accounts.
There are a few barriers to entry for someone just getting started in the world of investing. Education is a big one but that can be fixed with a little studying. Fees are another big reason. Usually, new investors will want to invest small amounts of money and add to it over time. Investment funds are suitable for those wishing to invest, say, £50 at a time whereas buying £50 of shares in an individual company would be a very bad idea due to the fees imposed.
Wouldn’t it be great if we could get a decent return our on money in an easy-to-understand way without crazy fees getting in our way? Well, there is, and it’s called social lending, or peer-to-peer (P2P) lending.
What is social lending?
Well, remember when your parents told you how banks work? They take deposits from customers and lend those deposits to others via personal loans, business loans and mortgages. Well, in today’s society, the banks are clearly involved in much more
dangerous exciting activities than good old-fashioned savings and loans.
Social lending companies basically offer the same services as traditional retail banks. They borrow money from some people and lend it to others. The rates offered by these companies are usually favourable to both lenders and borrowers when compared to the offerings of the major banks. For example, over the last couple of years, I’ve been making 7%+ on the money I’ve lent out. Try getting that kind of return from a savings account or fixed term bond.
How does it work?
Social lending is a bit different to retail banking. It basically works like this:
- Transfer money into your social lending holding account
- Set your preferences to control how that money will be lent out
- The money is combined with money from others to form loans
- Those loans are then lent to borrowers
The borrower pays monthly instalments on the loan and you receive the interest that is attributable to your portion of the loan.
Jonny Peasant wants to buy a car so he takes out a loan with a social lending company for £10,000. The social lending company uses £10 from 1000 lenders to form the loan. One of those lenders is Jane King. When Jonny makes repayments, the lending company takes a commission and returns the remaining money to the lenders.The money is lent to Jonny at 9% and people like Jane receive 7%. Jonny is happy because he has his car. Jane is happy because she is winning at personal finance and the company is happy because they’re getting a nice slice of the action, although it’s a smaller slice than the banks would be getting!
What are the risks?
Like any other type of investment, there are risks involved in social lending. The first is the risk of borrowers defaulting on (not paying back) their loans. This is a real risk but is very easily rectified through diversification. If you lend money through social lending platforms, you should expect to incur an occasional loss through bad debt. However, when you’re lending small amounts of money at high rates to many people, these infrequent losses combined with your large profits average out to make a nice rate of return.
The other risk is the risk of the social lending company going bankrupt. Unlike savings in retail banks, social lending accounts are not protected by the Financial Services Compensation Scheme. Therefore, if the company folds, you could lose your money. Again, this risk can be reduced by diversification. I personally invest via 3 different social lending companies.
Social lending is easy to understand. However, it does come with a couple of risks and they should be understood. The returns can be great but you may need to tie up your money for a while. There are three main companies offering peer-to-peer lending services in the UK and they operate slightly differently. It is important to also note that these companies report their interest rates in different ways so when comparing rates make sure you compare like for like by taking into account both fees and bad debt.
This article is part 1 of a 4 part series. Stay tuned for the next three parts, where we will discuss the main social lending services offered in the UK.