%img src=/

/media/article-images/Money/Loan.jpg?h=201&w=300&as=1 /%After standing unchallenged in the market for almost five years, social lender Zopa has now got some competition. With the market for social lending continuing to grow, we explain how it works and whether it might be the right option for you.

The three main peer-to-peer lending platforms Zopa, RateSetter and YES-Secure all operate in the same way. How the premise works is that consumers with money to spare offer unsecured loans to individual borrowers, cutting out banks and their inflated profit margins altogether.

An alternative to low-interest savings

Interest rates are painfully low at present, with inflation currently swallowing up the gains available on most accounts in the market. Social borrowing offers an alternative to these low rates, giving consumers the option of lending direct to consumers who are looking for an unsecured loan.

The idea, in a nutshell, is to bypass the banks. Normally, banks lend out our savings at high interest rates and pay savers a fraction of their earnings. Here, savers can earn much more by lending directly, whilst offering more attractive interest rates to borrowers.

Zopa, for example, offers lenders an average return of 8.1 per cent which, even after fees and before bad debt, beats inflation by some margin.

But isnt it risky?

Who you are lending to will depend on the site you choose some allow you to select your borrower based on a reliability score and their reasons for borrowing, while others will give you the option of spreading your lending across a number of borrowers chosen by the site.

As a result, the sites argue that the risk of taking on bad debt is relatively low, though each has a different process for outlining the risk a certain borrower poses. Zopa and YES-Secure use categorisations to communicate the risk level of each borrower, while Ratesetter uses an altogether different method — charging a monthly Credit Rate that varies according to a customers perceived creditworthiness.

Despite all this, its important to note that there is an inherent associated risk involved when lending through such websites. Peer-to-peer sites not covered by the Financial Services Compensation Scheme (FSCS), which offers compensation of up to 50,000 to individual customers should their financial institution go under. As a result, if a site goes bust, you may have little chance of getting your money back.

How borrowers can take advantage

With the banks out of the way, those looking to borrow are also able to take advantage of some competitive rates when heading to peer-to-peer lenders.

RateSetter, for example, advertises a typical annual interest rate of just 5.9 per cent on its rolling loans, which facilitate borrowing lasting anywhere between 1 and 40 months, and working in a similar way to credit cards.

On top of that, several peer-to-peer sites offer the option to pay off your loan early without any additional charges something you wouldnt find in most high-street banks.

Aside from flexibility and low rates, potential borrowers are also be able to compare sites without hurting their credit profiles — the initial credit search used to get you provisional quotes is what is called a soft search and thus won’t affect the profile that other lenders and institutions are able to see.

So whats the catch?

While taking cash away from the banks may sound an attractive proposition, there are some downsides to consider before you make a decision on where to put your money.

For a start, while social lending websites may be promising to cut out the middle man, that doesnt mean they wont charge you for using their service, usually in the form of a small percentage that is tacked on to the loan rate, or a flat usage fee.

The lending periods can also be long and inflexible at times, while borrowing is often unavailable or at least more expensive for anyone under the age of 24 or those with poorer credit histories.

Lenders will also earn nothing until your money is lent out to a fellow user. This means you could be missing out on earning for some time, whereas you would usually start accruing interest immediately if investing in a savings account or ISA.

And aside from the added risk of your money not being protected by the FSCS theres also the hassle and potential added cost involved should a chosen borrower fall into arrears, even if the risk is relatively low. While most peer-to-peer sites promise to chase a debtor on your behalf, some will pass on the cost of doing so by deducting a fee from your earnings.

However, you can opt to lend to a large number of borrowers, thus reducing the impact of any one default.

Want more help choosing?

For more tips on choosing the right form of borrowing, see our guide to grabbing a cheap personal loan. Savers, meanwhile, can head to our latest Savings Watch round-up for all the latest on maximising their money.