There has been much talk on our discussion boards about lender returns at Zopa and how we calculate them.
Zopa loans are capital and interest loans – with borrowers repaying an amount each month that is partly a repayment of a portion of the original loan, and partly the interest accrued on the remaining outstanding loan since the last payment was made.
Let’s assume a lender lends £100 to an individual borrower at an interest rate of 8% over 1 year – a perfectly realistic occurrence at Zopa.
Now, because Zopa loans are capital and interest, what is actually being repaid by the borrower to this lender each month is a portion of the £100 and an interest charge of 8% on the outstanding balance over the last month. Each monthly payment by the borrower to the lender in this example will be of £8.69. In the earlier months the proportion of this amount that is interest will be higher, and will get smaller over the period of the loan as the amount of the outstanding balance gets smaller with each payment each month.
So throughout the loan, interest has indeed been paid at 8%, but because this has been on a reducing loan balance, it can end up looking like a lower rate. In this example for instance, if you add up the twelve payments of £8.69, you end up with £104.28 – and thus the appearance of a return of just over 4%, not the actual 8% that was being charged in interest.
But looking at it more closely, the full £100 was not earning interest for the lender for the full year, but rather interest was being earned on a reducing sum, which over the year averages something like half the original loan amount, around £50.
This is how a loan at an interest rate of 8% can end up looking like a loan at 4%. It’s all down to the fact that it is a capital and interest arrangement, not interest-only.
Those lenders looking to receive an actual return of 8% on their £100 obviously need to take steps to keep their £100 loaned out, to counteract the effect that a capital and interest arrangement has in terms of its gradually reducing outstanding loan amount.
The easiest way to do this is to select our ‘auto re-lend’ facility. Here, as the borrower makes his payments each month, they will be automatically offered again on the same marketplace (same risk category and term) and at the same interest rate.
The net effect of this re-lending, assuming the money was taken up straight away by another borrower, would be an ongoing return of just over 8% (as the interest part of the monthly repayments would be slowly increasing the amount the lender has lent out beyond the original £100).
In reality there is likely to be something of a lag in the take up of these automatically re-lent amounts by borrowers, depending on how competitive an interest rate their offer is at the time. But, do remember though that before the money is re-lent, it will be sitting in your holding account (on offer again, in processing or even pending you offering it back on the markets) where it will be earning interest, currently 5% (and tied to Bank of England base rate). This will serve to help mitigate any loss of interest during the time before the money is taken up by borrowers again.
There are very significant advantages associated with the capital and interest model that Zopa uses.
Lenders enjoy a more sensible pattern of interest and repayments – larger, level amounts over the term of the loan – rather than tiny payments of just interest each month and then one big repayment of the original loan amount at the end of the term as they would under the interest-only alternative. In other words, this minimises the amount of money that has to be re-lent at any one time.
Perhaps more significantly, borrowers benefit from a more sensible repayment pattern of ‘equal instalments’ with the loan reaching nil by the end of the term. Under an interest-only arrangement they would be faced with suddenly having to repay the full original amount in one payment at the end of the term, radically increasing the chances of default. This of course would hurt not just the borrower, but also the lender.