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Returns edge down at Zopa as new investors chase higher interest rates

A quick update on Zopa, the UK-based peer-to-peer lender that has been proving its worth for both lenders and borrowers during the credit crunch.

As I wrote last month, interest rates had been rising for Zopa lenders, but the spike up in bad debt that I feared might have occurred due to the credit crunch hasn’t materialized so far.

Higher rates are good news for Zopa lenders, and that news has spread: Zopa is cropping up in the press more often and on money-minded bulletin boards. As a result, more people have joined Zopa.

The bad news for lenders is Zopa is a market governed by supply and demand. The influx of new money has brought rates down, and I’ve had to reduce the rate on my main offer to 8% to stay competitive.

That’s still more than double what I could get from a savings account (though that is NOT a direct comparison, since Zopa has a very different risk profile, more comparable perhaps to corporate bonds).

But the drop does highlight a couple of problems for Zopa lenders.

Lower rates and the risks for lenders

Falling interest rates highlight two problems for lenders.

Problem 1: Lower interest rates mean lower returns

Pretty obvious, this one!

As mentioned, I’ve had to reduce the rate on my main offer to A* lenders over 36 month terms to 8% to make my money really competitive again.

This points to an expected return of 7%, according to Zopa’s bad debt projections; great versus cash savings at 3%, but not so great compared to the 8.5% return I was getting just a few weeks ago.

Other lenders might instead choose to sit on their cash and hope the rush of new money slows to a trickle, prompting rates to rise again. (At the moment there’s about £1.3 million being offered by Zopa lenders at various rates).

The trouble with that strategy is you’re left sitting with cash un-invested, for which you’re currently paid 0.75% per year. (The Bank of England base rate minus 0.75%). Not very attractive, and I prefer to keep my money moving.

Problem 2: Lower rates may encourage borrowers to re-borrow

A big problem with Zopa from a lender’s perspective is that borrowers can repay their loans whenever they like, with no penalties.

As a citizen of the world I think that’s fabulous. I hate debt and urge anyone in debt to get out as soon as possible.

But as a Zopa lender, it’s a bad deal.

Think about it. I’m risking my money for a certain rate of return, and am prepared to lock it away for three years and run the risk of the borrower defaulting. But I can’t guarantee the rate of return I’ll receive for taking that risk, because my borrowers can return their money whenever they like, forcing me to re-lend it on new terms.

In contrast, with fixed rate savings accounts or bonds, you know you’ll get a certain return for the life of your investment, provided the latter doesn’t default. That’s a far more balanced risk/return situation.

Two potential consequences of this favouring of borrowers:

  • Over time, good borrowers may tend to repay their loans early, while bad borrowers may tend to default. There’s NO evidence this is happening yet (bad debt at Zopa is lower than expected at launch) but it seems to me a potential skewing. That would reduce returns long-term.
  • Switched-on borrowers who are able to may repay their loans early and then re-borrow at lower rates.

It’s possible that the latter is happening, or it might just be that good borrowers are paying down debt because of economic fears.

Either way, I was surprised to see I had £280 out on offer when I logged into Zopa yesterday, having had nearly all my money lent out a short while ago. This can’t have all come back from scheduled repayments.

I did receive an affiliate payment because somebody signed up to Zopa after reading about it here, but that only a explains a small fraction of the influx of cash into my account.

From a quick scoot about the many screens on Zopa, I can’t tell exactly if the money has come from repaid loans (do contact me if you know how), but it seems the only explanation.

Jury still out on Zopa long-term

I get a lot of traffic to Monevator from people searching for information on Zopa.

The company itself has been kind enough to link to me from the Zopa blog, and as mentioned I also get a small payment if anybody signs up to Zopa after linking through from this website.

Some unscrupulous people would perhaps capitalize on this traffic by urging readers to open Zopa accounts, and play down any risks.

For me though Zopa is still a rather speculative investment, and I’d suggest it shouldn’t be allocated more than a few percent of your total portfolio.

Do not mistake Zopa as a substitute for cash savings. It is nothing like as secure, is more time-consuming to manage and peer-to-peer lending can be expected to behave differently as an asset class over time.

I’ll be following up soon with a post about the differences between Zopa and cash savings, so do stay-in-touch if you want to learn more.

Zopa is an excellent and exciting addition to the tools we private investors have at our disposal. Don’t let me scare you off signing up if you understand the differences between Zopa and cash savings.

Just don’t think Zopa is the same as a cash savings account. It’s not.

Update: Reader ‘Dave’ has emailed me with some tips on navigating the Zopa screens mentioned above:

I response to your Zopa question I offer this advice, I hope it helps.

You can check payments into your Zopa account by clicking ‘Lending’ then ‘Account’.

Alternatively, you could open up ‘My loan book’ from the lending screen and see if any loans have moved into ‘Closed’.

To check for extra payments I tend to look at my ‘On time’ borrowers and order the table by % repaid.

Reader ‘Nigel’ also added:

Further to David’s comment about tracking your ZOPA repayments, my favourite method is “Loan book” ==> “Advanced options”. Here you can select for 28 columns headings inc. % repaid & lots of other useful things.

Thanks guys – I’ll try these tips out, and have posted here for other readers’ interest.

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