FOOL'S EYE VIEW
Introducing The People's Bank

By Jane Mack (TMFJane)
March 8, 2005

Unless you've had your head in the sand over the last few days, you can't have failed to hear about the latest dot-com phenomenon, Zopa. It stands for Zone of Possible Agreement, which sounds like the sort of place Dr Who might enjoy visiting in his Tardis, but, in fact, it's a website which allows people to borrow money from each other, rather than using a bank or building society.

The idea is that those with money to spare can choose what rate to lend at and, by looking at the markets, decide what sort of people to lend to and when. Borrowers can choose to take a rate offered or wait and see whether a lender pops up offering a better rate. Both sides enter into a legally binding contract with their respective borrowers and lenders with Zopa managing the collection of monthly repayments. If a borrower doesn't pay on time or defaults, Zopa uses the same recovery processes used by the high street banks.

It's authorised by the Financial Services Authority and has received the necessary credit licences to operate from the Office of Fair Trading.

In theory, it shouldn't work but in practice, even in these early days, it looks as if it might.

How it works for the lender

• You can lend up to £25,000 on Zopa. This can be lent in one single offer or split up into a number of different offers in different markets at different rates.
• You must make offers in multiples of £500.
• Any money you offer to lend is split up between 50 different borrowers to spread any risk of default.
• You lend no more than £200 to any one borrower.
• All applicants are given a credit score (categories A, B, C or D where A is the best credit rating) by the credit reference agency Equifax. Only those who fall into categories A and B are allowed to borrow through Zopa. 
• You can't choose which individuals to lend to - you only choose which of the two markets to lend to ie: borrowers classified as extremely creditworthy (Market A) or those who are marginally a higher risk (Market B)
• The rate you choose is an Annual Equivalent Rate (AER), and you only earn this return on money that is currently lent out. As you receive the monthly repayments from your borrowers you will need to re-lend this money to get the full amount of interest.
• Zopa says that because of the way they're set up, it takes up to 3 days to get your money into the system, and, once it is lent, a minimum of a year to get it back out of the system again

Note that in order to get the full return on your investment, you have to re-invest your money as and when you get it back and, as you have to re-lend in multiples of £500 you'd need to wait until you get at least that much back from your borrowers (or have an extra stash of spare cash) in order to keep your money constantly in the market earning interest.

How it works for the borrower

• You can borrow up to £25,000 in multiples of £1,000.
• Zopa charges a fee of 1% of your loan
• You can pay off the outstanding amount on your loan at any time without penalty although you will still have to pay the Zopa exchange fee of 1%.
• If you miss a payment and have failed to contact Zopa to warn them of a potential payment problem, they may charge you £20.
• If you don't repay on time the credit reference agency will be informed which could affect your ability to get credit in the future.
• If you default completely, your debt will be sold to a debt collection agency who will chase you for the money on the lender's behalf.
• You can only take out one loan at a time with Zopa.

So far so good - and here's why it shouldn't work.

Let's say, as a lender, you've got £5,000 that you can lock away for two years. Currently, you can get a two-year fixed rate bond that offers 5.45% AER. At the end of the two years, you'll have earned £560 on your £5,000 which has been safely tucked away in a hassle-free account that you don't have to pay any attention to.

If you preferred to lend the money to Zopa borrowers, you'd probably want a little extra interest to compensate for the fact that, as your money is repaid each month, you'll need to put it in a high-interest savings account, or back into Zopa, to continue to earn the same rate of return. (For simplicity, we'll ignore the fact that your money is also at risk of default, albeit a very marginal risk since the money is spread between borrowers.) So let's say you're prepared to lend your money at 6%. 

Your borrowers will be looking at paying an effective rate of 6.5% (if you spread Zopa's 1% charge over the two years of the loan). Now, if you check out our Loans Centre, you'll see that both the Alliance & Leicester and Lombard Direct are offering personal loans at a typical interest rate of 5.9% ('typical' meaning that at least 66% of successful applicants will get that low rate).

So, you have to ask yourself why someone with a Zopa creditworthiness rating of A or B would choose to borrow money from Zopa lenders over two years at 6.5% when they are pretty likely to qualify for a loan charging just 5.9%?

Zopa in action

That's the theory about why it shouldn't work - but the reality, although it's early days, is currently showing a very different picture.

You have to join to see the information but at the time of writing, there are 22 lenders offering various sums at various rates over various periods to the Market B category. The cheapest rate on offer for two years is 7% (i.e.: effectively 7.5% for the borrower with Zopa's 1% charge spread over the two years) from a lender who is offering £7,000. The most expensive rate is from a lender offering £1,000 over two years at 9.5% (i.e.: effectively 10% to the borrower). Not a bad return for either lender.

However, when looking at the most recent offers accepted by borrowers over two years, it seems five out of the seven currently on display have agreed to pay no less than 9.6% in interest to lenders whose offers have already been taken up.

(The reason for this is when someone asks to borrow money, it is taken from each lender in order of the cheapest interest rate on offer until the full amount has been matched. The interest rate that the borrower is charged for the loan is the rate the last lender to supply money has agreed to lend at. All lenders receive that rate, even if it is higher than the rates they themselves set).

The fact is, there is clearly a market here offering a healthy return to lenders with borrowers prepared to pay higher rates than they could possibly get from lenders in the High Street. It's also worth pointing out that many of the best rates from mainstream lenders only apply when you borrow £5,000 or more. If you want to borrow £2,000 say, the cheapest rate currently available is 6.7% and only a handful charge less than 8%.

Summary

In conclusion, I would say that the Zopa marketplace may well be a good place for someone to put their money - as long as you're prepared to accept a smallish risk of default and the requirement to ensure your money is constantly re-invested. I can quite see that for those who quite like a bit of a gamble that it could be rather fun playing at being a banker.

For the borrower with an A or B credit rating though - unless they only want to borrow a small amount - there are better deals on the High Street!

Borrowers need look no further than our Personal Loan Centre. 'Lenders' who prefer to save in a more conventional fashion should check out our Savings Centre.