There’s an old English proverb that says necessity is the mother of invention. It means that when times are tough, people will develop things to make them easier.
This is exactly what’s happened in the face of miserly interest rates offering savers next to no return on their savings, and eye-patch-wearing bankers robbing borrowers blind.
The invention is peer-to-peer lending.
With the RBA about to down tools for the year, official interest rates are on hold at a tiny 2.5 per cent, which is great news if you’re saddling up a mortgage, but sucks for savers wanting to earn interest on their stash of cash.
In the face of these tough times, some super sharp finance types have developed an innovative solution for savers, and it happens to help out borrowers too. But is it something you should be dabbling in?
We dug into the dirt and cornered RateSetter CEO Daniel Foggo to get you the low-down.
What is peer-to-peer lending?
Peer-to-peer lending platforms are a bit like banks, but without the ginormous profit margins.
They’re online middle-men that allow people to borrow or lend money directly to each other. As a lender on a peer-to-peer platform, you’re essentially investing in a portfolio of consumer loans.
“Rather than pick individual borrowers to lend to, lenders only have to specify the amount, term and interest rate they want to have their funds invested at. Our technology platform then matches them to creditworthy borrowers,” Foggo explains.
“As a lender your funds might be matched to just one loan, or to multiple loans, although generally over time a lenders’ funds will be matched to numerous different borrowers at any one time.”
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So because you’re lending to a bunch of Joe Bloggs’ for them to buy cars, wheelbarrows or whatever else they might need the money for, you need to commit to the loan for a certain length of time, like a term deposit.
Now, this makes it riskier than traditional lending because you’re relying on other people to pay you back. However, it also means more attractive interest rates to compensate you for taking on that additional risk.
The peer-to-peer market is well established in the UK and US, but is just kicking off Down Under.
What interest rate can you earn?
The only retail lending platform in Australia at the moment is RateSetter, hence our interview with the head honcho, and they offer annualised interest rates of between 6 per cent for a one month loan to 9.5 per cent for a five year loan.
That’s pretty juicy when you consider the best savings accounts on the market right now tip in a measly 3.5 per cent.
Direct Money and Society One are a couple of other peer-to-peer platforms gearing up for launch, but at the moment are only open to the well-heeled investors.
What are the odds of default?
Slim, in most cases.
“As we’ve only just launched in Australia our track record is a little skewed, as we have no defaults,” Foggo says. “It’s best to look at this in the context of our UK track record. In the UK, RateSetter’s default rate is about 0.6%.”
To keep that default rate down, companies like RateSetter run borrowers through a pretty tight examination when they apply.
“Our borrowers are people who might otherwise have got money from a bank. We assess a number of factors, including an applicant’s financial situation, their credit history, and the term and type of loan they want. Importantly, we also check borrowers are who they say they are.”
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And when there are defaults, in Rate Setter’s case, there’s a provision fund to draw on. This is essentially a pool of funds held for lenders that can be used to compensate them for any shortfall in principal or interest owed.
“The Provision Fund is intended to build up over time, and lenders can see on our website the amounts in the fund and the ‘coverage ratio’ of funds to expected borrower defaults,” Foggo assures us.
So it’s a pretty transparent platform, where you can see the amount of ‘insurance’ that’s backing your loan.
While this doesn’t guarantee that every lender will get their money back, it’s a pretty solid system that has worked exceptionally well in the UK where no lender has lost money on their investment with RateSetter.
What cut does the operator take?
Borrowers are charged a fee when they take out a loan, which varies depending on the term of the loan. And, as Foggo explains, lenders cop a small hit too.
“We also charge a small fee to our lenders, which we call the interest margin fee. This fee is set at 10 per cent of the amount of interest that the investor earns. For example, if a lender earned $500 of interest on the loans to which their funds were matched, RateSetter would charge an interest margin fee of $50.”
To keep things simple, all rates displayed to lenders on the site are after the interest margin fee.
So, that’s the crux of it. Not a bad place for borrowers, and a really good one for savers with a transparent platform offering damn sharp returns. Don’t take that as financial advice, just an invitation to learn more if your savings are being whittled away by inflation in a low interest account.
After all, if someone’s gone to the effort of inventing something to make things easier, chances are you should get on board.
Image: Otis Blank, via Flickr