Social lending - what's it all about?

Banking conditions aren't particularly inviting for savers or borrowers at the moment, with miserly rates on savings and sky-high rates on loans causing both parties to lose out.

So it's little wonder that social lending – a practice where individuals lend money to each other, sidestepping the banks – is booming.

With lenders receiving a higher rate of return than from a regular savings account, and borrowers securing loans at a lower interest rate than that offered by the banks – it seems like a good idea all round.

So what exactly is social lending and how does it work?

Zopa is the first and largest social lending website in the UK, having organised around £50 million worth of loans between ordinary individuals like you and me.

It works on the premise that with such low overheads compared to the big banks – both borrowers and lenders can enjoy favourable interest rates by cutting out the middleman. The current rates are certainly more attractive than those offered by the banks at the moment – at between 8% and 10%.

The idea is quite simple really. Say I had £1,000 to spare that I might normally put in a savings account. I go online, say how much I can lend and at what rate of interest, and wait for interested borrowers to take me up on the offer. If we both agree, the deal goes ahead.

It might sound fraught with potential problems, but Zopa has a strict set of criteria to make it run as smoothly as possible.

Secure lending
Borrowers undergo credit checks through credit reference agency, Equifax, and those that don't fit the bill, are unable to use the service.

To reduce the risk to lenders, Zopa splits the sum. So my £1,000 for example, would be spread across 100 borrowers to significantly cut the loss to me if one borrower were to default on repayments.

Legally binding contracts are drawn up by Zopa, and the loans are repaid monthly by direct debit. If any repayments are missed, a collections agency uses the same recovery process as the high street banks.

What does it cost?
Borrowers are charged a £118.50 transaction fee, which is added to the loan amount, and there's no early repayment charge.

Lenders pay an annual 1% fee on the amount they lend to borrowers, which is deducted monthly from the holding account balance. So if I lent my £1,000 at 8%, I would earn £80 in interest each year - minus the 1% service charge of £10.

The popularity of Zopa here and in the US shows that the simple idea of bringing people together to lend and borrow money on favourable terms is hugely successful.

I think the loss of consumer faith in the profit-hungry big boy banks will only strengthen the social lending market.