Peer-to-peer lending, also called P2P lending, is a financial innovation that enables borrowers to obtain unsecured personal loans from multiple investors who seek to earn higher interest returns on their investments, bypassing the need for a financial institution to act as an intermediary. Peer to Peer lending is facilitated by platforms that are predominantly technology-based companies that operate as aggregators for lenders and borrowers, effectively matching them with each other.
P2P platforms engage in microfinance activities with the primary aim of making a social impact by providing easier access to credit for small entrepreneurs. P2P lending has enabled many people to lend money directly to potential borrowers in a convenient and hassle-free way, without involving traditional banks and financial institutions.
How does P2P lending work?
Upon registering on the P2P lending platform, borrowers and lenders undergo a due diligence process. The platform conducts an evaluation and approves those who meet their criteria to participate in lending or borrowing activities. The loan applicant can be either an individual or a business entity in need of financial assistance. However, for ease of understanding we will assume the borrower to be an individual for this article.
After registering on the P2P lending platform, the borrowers can list their requirements like the amount of loan required, purpose of the loan, duration and rate of interest expected.
Similarly, after registering on the P2P lending platform, lenders are provided access to the details of the borrowers, such as the amount required, credit score and the purpose of the loan. Lenders can bid on the borrower's loan proposal and the borrower can then accept or reject the offer. This process is called the ‘reverse auction’ model.
After the borrower and the lender come to an agreement, they sign a formal contract and the loan amount is then transferred to the borrower's account. The borrower then makes periodic repayments, typically in the form of equated monthly installments (EMI), over the specified time period. P2P lending platforms offer a simple and transparent technology-based platform to facilitate a smooth and quick lending process.
Interest rate
Borrowers can expect to pay a higher interest rate for loans obtained from P2P lending platforms compared to those obtained from banks or financial institutions, but lower than the rates charged by credit card companies.
On the other hand, lenders can earn higher interest rates on the amount they loan through P2P lending platforms as compared to the interest rates earned on fixed deposits or other debt instruments.
The interest rate can be determined or suggested by the P2P lending platform or agreed upon through mutual consensus between the borrower and lender. P2P lending platforms have varying interest rate models and methodologies for calculating them. These range from a fixed, flat rate set by the platform to dynamic rates that are agreed upon by the borrowers and lenders. Additionally, some platforms use a cost-plus model that includes operational expenses and margins for the platform, as well as returns for the lender.
The interest rate is ultimately decided by the lender and the borrower and the P2P platform does not guarantee a fixed or minimum rate of return to any lender.
Fees
P2P lending platforms serve as intermediaries that connect borrowers and lenders through a single online platform. They act as facilitators and do not derive their revenue from the interest charged by the lenders. Instead, they charge fees to both borrowers and lenders for the services they offer. Borrowers are required to pay an origination fee, which may be a flat rate or a percentage of the loan amount based on their risk level. Lenders, on the other hand, may need to pay an administrative fee, as well as an extra charge if they opt to use any supplementary services such as legal advice that the platform offers, depending on the platform's policies.
Services
As mentioned above, the primary service offered by P2P lending platforms is the platform itself which connects the individuals seeking credit and those willing to lend their funds. The P2P lending platform also offers various services, including collecting loan repayments and conducting preliminary creditworthiness evaluations of the borrower. The fees charged by the platform cover the costs of providing these services, as well as other business-related expenses. In addition to connecting borrowers with lenders, P2P lending platforms may also offer additional services such as collecting funds from investors and disbursing them to borrowers. These transactions are conducted through an escrow account maintained by the platform, which is monitored by the trustee appointed by the bank in which the escrow account is maintained.
Advantages of P2P
For Borrowers:
Individuals who have either no credit history or a low credit score and have been unable to obtain loans from banks or financial institutions can avail credit from P2P lending platforms. Another advantage of P2P lending platforms is that borrowers can obtain loans at lower interest rates compared to those offered by credit card companies or unorganized sector money lenders.
For Lenders:
P2P lending presents an opportunity to earn higher returns than those available through conventional investment options. Lenders can diversify their investment by lending small amounts to multiple borrowers, instead of lending a large sum to a single borrower. Lenders have the opportunity to earn passive income since they receive monthly EMI payments against the loan.
Risks involved:
For Borrowers:
Since borrowers need to provide a lot of personal information to the platform, borrowers should ensure that the P2P lending platform they use for availing a loan is authentic and reliable before taking a loan. In case of any data leak their personal information might be compromised and available to unauthorised parties. It is also advisable to research whether other borrowers have faced any harassment from the lenders registered on the platform for loan repayment.
For Lenders:
The primary risk that lenders take on when lending through P2P lending platforms is the credit risk, which would typically be assumed by banks or financial institutions. Credit risk is the risk that a borrower will default on a loan by failing to make payments that are due. It is the risk that the lender will lose the principal or the interest or both. The lending platforms do not provide any guarantee regarding the repayment of the loan and the interest by the borrower. Since most of the loans through P2P lending platforms are typically taken by individuals with a lower credit score or those who are unable to obtain loans from banks, the credit default risk associated with these loans is generally higher compared to loans given by banks or financial institutions.
Should you lend on P2P lending platforms?
It is important to recognise that lending on P2P lending platforms involves significant risks and should not be viewed as an investment. The potential risks outweigh the returns associated with this type of lending. Therefore, the risk-to-reward ratio is generally not favourable for lending on P2P platforms. The loans are unsecured and legal action to recover the amount can be a costly and time-consuming process. The higher credit risk associated with such loans means that any defaults can have a significant impact on your returns. For instance, if you lend Rs. 10,000 each to 10 borrowers at an average interest rate of 18%, and one borrower defaults on the loan, you would only receive Rs. 1,06,200 ((90,000*18%)+90,000) rupees at the end of the year. Therefore, the return generated is only 6.2% as against the 18% expected return. Investing in mutual funds may be a better option as it can offer a return of 10-12% with comparatively lower risks than P2P lending.
In conclusion, P2P lending platforms provide a unique alternative to traditional lending institutions, offering borrowers access to credit and lenders an opportunity to earn passive income. However, borrowers must be cautious and verify the authenticity of the lending platform, while lenders must be aware of the credit risk associated with such loans. While the returns may be attractive, the risks should not be ignored and investing in other instruments like mutual funds may offer a better risk-reward ratio.
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