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Guide to social lending

Depending on the financial situation, social lending is either a way to earn big returns on cash or borrow on the cheap. It cuts out the banking middleman, by matching compatible borrowers with willing lenders, there by cutting costs.

Also known as crowd lending or peer-to-peer lending, social lending is fast becoming more popular with savers as an alternative to traditional savings accounts, due to the very low interest rates available from high street banks since the Bank of England base rate fell to 0.5%.

Social Lending works well for people that are happy to lock their cash away and are willing to take a risk, as social lending is more like an investment than a saving. However, there are still procedures that need to be undertaken. Borrowers undergo rigorous credit checks and are rated according to risk, with lenders able to earn higher returns if they are willing to increase risk.

How does social lending work for savers?

While all social lending sites do operate in slightly different ways, the concept is the same. Businesses and individuals with surplus cash can choose to lend as much or as little (minimum is usually less than £50) as they are comfortable with, and for how long.

Rather than the cash being stashed away in a bank account, and used by the bank or other financial institution, it is loaned out to borrowers, with the site acting as the administrator. The funds are usually split up into small chunks and given to a number of borrowers to limit the risk of losing money.

Savers, or lenders as they are in this case, receive their returns each month as the borrower makes the repayment. This includes the original money loaned out plus an interest payment (minus the fee from the site).

How much can I earn from peer-to-peer lending?

Just like with a savings account or traditional investment, the return that lenders will get for lending their money depends on the social lending site.

The market leaders seem to have similar expectations, suggesting that investors will make around 3-6%, but some of the new and smaller sites claim to be able to offer anything up to 10%. It is important to check whether the advertised returns are gross or net, as the site takes a commission or fee, which might not have been accounted for which can rapidly change the amount you eventually get.

Whether you take a low risk and earn a low return, or a high risk and a high return, the yield is likely to be more than if you locked away the same amount of money in a savings account.

Tax on social lending

It’s very simple: any interest earned is subject to income tax, just as with normal savings. So, basic rate taxpayers will see their earnings cut by 20%, higher rate 40% and top rate 45%. Returns are usually paid without any tax deducted at source, so savers will have to declare earnings to HM Revenue & Customers (HMRC) by including interest earned on their tax return.

One downside to the way social lending differs from savings is that tax is paid on the interest, even with bad debts. So this means the lender must understand that even if their investment is not repaid in full, they may still have to pay the full tax on the interest originally set out.

HMRC states: “An individual lending as part of an investment would need to pay tax on the gross interest income earned. There is no relief for bad debts or platform fees.”

Essentially, this means that for sites where the rate offered is before bad debts, savers will be taxed at the original rate, sometimes reducing the rate of return substantially.

Why is social lending increasing in popularity?

It’s clear to see that social lending is becoming a more popular way to earn money as the Peer-to-Peer Finance Association figures claim that the sector doubled in size in 2013.

This massive growth is largely down to the paltry interest rates on offer to savers due to the low base rate, but other factors such as the lending freeze and numerous financial scandals relating to the banking sector have also fuelled its popularity. It is possible that when the base rate increases, popularity may decrease as it is less risky to keep the money in a savings account.

Disadvantages of social lending

When it works well, social lending clearly has some advantages over traditional savings vehicles, but there downsides which must be considered.

The biggest cause for concern is not getting your loan repaid. Should the borrower default, there is a risk that the lender won’t get any interest or their original capital back. The same applies if the money isn’t borrowed – no interest is paid when the cash is waiting to be loaned.

There is also the lack of financial protection: social lending is not covered by the Financial Services Compensation Scheme (FSCS). This government backed scheme guarantees savings of up to £85,000 and covers all savings accounts. However, the industry is now policed by the Financial Conduct Authority (FCA), meaning that there will be further rules introduced to protect investments.

While there haven’t been any major scandals or horror stories directly associated with social lending YET, it is a very new industry, so it is important to be wary. Other new and similarly unregulated products, like ‘mini-bonds’ have seen investors lured with high interest rates lose thousand when their ‘mini-bond’ of them collapsed, with no recourse other than via the administrators.