RateSetter: how ordinary people can lend to save

RateSetter is a peer-to-peer lender that allows you to get a decent return on your cash, even if you're only lending small amounts. But the advantages of RateSetter for amateur investors could be its undoing.

If you're looking to get a better return on your savings than you can get in savings accounts, you should consider peer-to-peer lenders, which enable savers like you to lend your money to ordinary people. 

Zopa, Funding Circle and RateSetter are the three biggest players. They have established themselves and built up a lot of trust. RateSetter is the smallest of the three, but I believe it has advantages over the other two for ordinary savers who want to keep things simple.

The whole peer-to-peer market has grown from nothing at the beginning of 2005 to more than £350 illion today. RateSetter has grown rapidly from its own beginnings. It matched £1 million of loans at the end of 2010 and in the first three months of this year it had a total of £40 million of savers' money on loan. 

Lenders have been earning around four percentage points more than they could get in a typical savings account. Borrowers have been paying around four percentage points less than with the average bank loan. It's working as intended.

How RateSetter works

RateSetter is the simplest of the big peer-to-peer services. All you have to do is choose the term you want to lend for and the interest rate you're willing to lend at. Bad debts are paid for from a separate fund. 

You can choose to lend as little as £10 on a rolling monthly basis, or over one, three, four or five years. The longer you choose to lend for, the higher the interest rate you'll usually be able to set.

When choosing the interest rate, you want to get the highest return possible, but you're competing with lots of other investors to win business from potential borrowers. If you set your rates too high, you won't lend any money at all.

Borrowers are very carefully vetted by RateSetter to limit the risk of default. RateSetter also has a bad-debt fund, called the Provision Fund, which is a unique invention in the peer-to-peer industry.

As a result of the Provision Fund, no RateSetter investors have lost any of their money so far, nor have they received less interest than they expected, no matter how badly their borrowers defaulted. Contrast this with other peer-to-peer services, where investors must take the hit of bad debt on their own loans, which not only makes the returns less certain, but it has sometimes resulted in losses. Indeed, Zopa has now launched its own version. Check out Get zero bad debt on Zopa for more.

The bad-debt fund now contains £890,000 against expected bad debt of £530,000, although actual bad debt has been far, far lower than anticipated so far, showing that RateSetter conservatively estimates expected bad debt. The historic default rate is just 0.36% of money lent out.

Investors pay 10% of their interest to RateSetter in fees. Part of this fee goes to the growing bad-debt fund – so ultimately investors do pay the costs of bad debt between them, it's just that the cost is more evenly spread and their expected rate of return is clearer from the start.

Balance the risks and rewards

Peer-to-peer lenders have been offering a way for investors to beat savings in a way that is low risk. The problem is that when something is seen as a low risk or even a no risk way to get higher returns than from savings accounts, everyone rushes to invest in it – with undesirable consequences.

This rush and its negative effects are already well under way. 

Savers and investors have been increasingly attracted to the higher rewards and lower risk in peer-to-peer, and have been putting more money into it. As a result, investors have had to set lower interest rates to compete with each other to lend their money out. This pushes investors' returns down. You can see the declines in the major players' rates in  Peer-to-peer investor returns fall to 5.1%.

I think RateSetter is generally seen as the lowest risk of all due to its Provision Fund. Investors in it are still taking the same extra risks of using RateSetter compared to using savings accounts, but their potential returns are getting lower and lower. It can reach the point where the returns are so low that it doesn't make sense to take the extra risk of loss any more - even if those risks usually aren't large.

Are the rewards too low for some investors?

It's possible that, for some RateSetter investors, this point has already been reached, or it is not far off.

The returns investors are currently getting on five-year loans are 5.4% after deducting the RateSetter fee. For a higher-rate taxpayer, this means an after-tax return of 3.24%. 

Compare this now to the Skipton Building Society's Five-Year Fixed-Rate Cash ISA, which pays 3% AER. Since this is a tax-free savings account, you're getting just a fraction less here, but with lower risks of losing any money in nominal terms.

The only two ways to lose money with Skipton is if the conservatively-managed building society fails or defrauds you, and the Government refuses to compensate you despite its promises, or by the Government simply taking money off you to save itself, rather like the Government of Cyprus did to many savers in its banks recently. Read Can banks take your savings?

Even if the Government has to save you from the building society's failure, it will pay you the interest you should have earned, too.

With RateSetter, on the other hand, additional gains of 0.24 percentage points per year could be more than wiped out during troubled economic times when default rates, even for prime borrowers, shoot upwards. 

Greater flexibility with RateSetter

Don't forget, though, that RateSetter comes with the potential advantage that each month you receive some of your investment back through the monthly repayments made by your borrowers. Quite often borrowers repay the whole loan early, too. 

This means you're able to reinvest at least some of your money, potentially at a higher rate, sooner. You can then take a fresh look at the difference between savings rates and RateSetter returns, and decide again whether the potential returns are still high enough to reinvest your money or whether to use savings accounts. 

Beware the bad times

RateSetter cannot do much to reduce the effect of investor competition reducing interest rates without causing negative side effects.

RateSetter currently accepts just 12 prime borrowers for every 100 applications. It could loosen these criteria, which would enable investors to charge more, especially since banks and other peer-to-peer lenders charge more for lower-quality borrowers. However, this obviously increases the risks of default too. 

Alternatively, it could reduce its fees to enable more money to stay in investors' pockets, but if it does so by a big margin it will probably have to reduce payments to the bad-debt fund too.

The two main attractions of RateSetter for amateurs are that little thinking is involved in selecting investments, and the Provision Fund. Both these features could be its undoing. As people become more relaxed about the risks, the least skilled investors will eventually set too low prices to ensure they “win” the bid to lend money.

Skilled investors will happily be eliminated from the auction at those prices, perhaps looking to the other peer-to-peer services where they can exercise their skills more by having greater say in their loan choices.

Like every other form of investment – stocks, bonds, gold, whatever – you cannot invest at all times and expect the risks to stay constantly small while the rewards always remain substantial and worthwhile. Investors eventually turn low-risk investments into high risk ones just by believing they're low risk.

Enjoy RateSetter in the good times, but bail out when the rewards seem too low for you compared to safer savings options. And don't come back again until other investors have lost money, and have become too scared to compete for borrowers.

Compare the returns you can get from peer-to-peer lending with Lovemoney.

More on peer-to-peer lending:

Get zero bad debt on Zopa

Peer-to-peer investor returns fall to 5.1%

Peer-to-peer lending set to be regulated

Why I've started saving with RateSetter

What is peer-to-peer (P2P) lending?