People in India have always had a habit of lending money to one another. Be it in the context of business communities, where people borrow money to satisfy working capital needs, or in the context of extended families supporting one another in times of need. Most of this lending is based only on trust, with no guarantee or collateral to back it up. This ancient method of lending, like every other part of our life, is being changed by technology. Peer-to-peer lending, often known as (P2P) lending, is a new modern version of lending to one another.
In this article, we will go through exactly what P2P lending is and how it works. We will also discuss its advantages, disadvantages, risks associated with it and more.
What is P2P Lending?
Peer-to-peer lending is a type of direct lending of money to individuals or businesses that do not include an official financial institution acting as an intermediary. P2P lending is typically done via online platforms that connect lenders with potential borrowers.
P2P lending offers both secured and unsecured loans. Yet, the majority of P2P lending loans are unsecured personal loans. In this sector, secured loans are rare and typically backed by luxury materials. Peer-to-peer lending is regarded as an alternate source of finance due to some key differentiating characteristics.
How does P2P Lending work?
Peer-to-peer lending is a relatively simple process. All transactions take place on a specific online platform. The following steps explain the general P2P lending process:
- A potential borrower interested in acquiring a loan fills out an online application on the peer-to-peer lending platform.
- The platform evaluates the application and determines the applicant’s risk and credit rating. After that, the applicant is given a suitable interest rate.
- The applicant receives the available alternatives from the investors after the application is accepted, according to his credit score and the allotted interest rates.
- The candidate might analyse the available possibilities and select one.
- The applicant is liable for making periodic (typically monthly) interest payments as well as repaying the principal amount when the loan matures.
The organisation that runs the online platform charges a fee for the services it provides to both borrowers and investors.
How is P2P Lending regulated in India?
Since peer-to-peer lending is a type of lending, it is regulated by the Reserve Bank of India (RBI). The RBI has established guidelines for how P2P lending platforms must operate. For example, businesses that wish to offer peer-to-peer lending services must apply with the RBI for an NBFC-P2P licence.
As the regulator, the RBI ensures that these platforms pose no significant systemic risk. Following RBI regulations, if a P2P platform decides to shut down, its board will follow a previously formulated Business Continuity Plan. The plan includes all of the specifics for safeguarding the information of all lenders and borrowers. Additionally, the plan contains information on loan servicing for the duration of the loan if the bank closes.
So, these are some of the regulatory measures put in place by the RBI to reduce the risks associated with peer-to-peer lending. However, investing in P2P lending is not without risk. It is classified as a high-risk investment product. We will learn more about the risks associated with peer-to-peer lending.
Advantages of P2P Lending
Peer-to-peer lending offers significant benefits to both borrowers and lenders:
1. Higher returns to investors
When compared to other types of investments, P2P lending generally provides higher returns to investors.
2. The more accessible source of funding
Peer-to-peer lending is a more easily accessible financing option for some borrowers than traditional loans from financial institutions. This might be brought on by the borrower’s poor credit standing or the loan’s unusual purpose.
3. Lower interest rates
Due to greater lender competition and lower origination fees, P2P loans typically have lower interest rates.
Disadvantages of peer-to-peer lending
There are some drawbacks to peer-to-peer lending:
1. Credit risk
Peer-to-peer loans are subject to significant credit risks. Many applicants for P2P loans have poor credit histories that prevent them from getting a traditional loan from a bank. This means a lender must be aware of the risk of a default by a counterparty.
2. No insurance/government protection
The government provides no insurance or government protection to lenders in the event of a borrower default.
3. Legislation
In some places, it is illegal to engage in peer-to-peer lending, and those that do must adhere to strict rules regarding investments. As a result, some borrowers and lenders may be unable to participate in peer-to-peer lending.
Understanding the risks
P2P lending may be risky for several reasons. Understanding these risks and how to lower them is helpful.
1. The risk of default
It’s possible that the person or company you lend money to won’t be able to repay it (this is known as “defaulting”). The greater the default rate on a P2P website, the more people or businesses are unable to repay their loans. The money you lend through a P2P website is not protected by the Financial Services Compensation Scheme, in contrast to the bank and building society savings.
In addition, there are several P2P websites with contingency funds or provide funds that are meant to pay borrowers who default on their loans. These provision funds differ greatly from one site to the next, so it’s critical to understand what’s covered if you’re considering becoming a lender.
2. The risk of early or late repayment
You might not make as much money as you had anticipated if your loan is paid off early or late. When a loan is paid off early, you can just lend it out again. However, there’s a chance you won’t be able to offer loans at the same interest rate.
3. The risk of the P2P site going bankrupt
If the P2P company itself shuts down, you might incur financial loss (as several have done).
However, if they are subject to FCA regulation (as all P2P lenders doing business in the UK must), they are required to keep lenders’ funds in ring-fenced accounts apart from their own.
Conclusion
At a time when banks are offering around 5% on 1-year FDs, the prospect of earning 12-14% per year through P2P lending appears appealing. However, there are risks associated with P2P lending investments as well. P2P lending investments carry a higher risk than equity fund investments.
Additionally, the investment product is still in its early stages. In 2017, the RBI began to regulate peer-to-peer lending. As a result, it has yet to go through its evolutionary cycles and may experience several unpleasant events. As a result, you should consider investing through P2P lending only if you are willing to increase the risk in your portfolio. The addition of P2P lending to your portfolio should not be used to replace fixed-income investments such as FDs and Debt Funds.
FAQs
1. What is Peer-to-Peer Lending in India?
Ans: Peer-to-peer lending is a type of direct lending of money to individuals or businesses that do not include an official financial institution acting as an intermediary. P2P lending is typically done via online platforms that connect lenders with potential borrowers. P2P lending offers both secured and unsecured loans.
2. How does P2P Lending work?
Ans: Peer-to-peer lending is a relatively simple process. All transactions take place on a specific online platform. The following steps explain the general P2P lending process:
- A potential borrower interested in acquiring a loan fills out an online application on the peer-to-peer lending platform.
- The platform evaluates the application and determines the applicant’s risk and credit rating. After that, the applicant is given a suitable interest rate.
- The applicant receives the available alternatives from the investors after the application is accepted, according to his credit score and the allotted interest rates.
- The candidate might analyse the available possibilities and select one.
- The applicant is liable for making periodic (typically monthly) interest payments as well as repaying the principal amount when the loan matures.
The organisation that runs the online platform charges a fee for the services it provides to both borrowers and investors.
3. How safe is Peer-to-Peer Lending?
Ans: Even though peer-to-peer lending is riskier than keeping money in a savings account or CD, the interest rates are frequently much higher. Investors on peer-to-peer lending platforms carry the majority of the risk, while banks or other financial institutions typically bear less of it.
4. How do you invest in Peer-to-Peer Lending?
Ans: The simplest way to get involved in peer-to-peer lending is to create an account on a website that facilitates the practice and start making loans to borrowers. In addition to allowing lenders to select their borrowers’ profiles, these sites typically offer lenders a choice of high-risk/high-return or modest-risk/moderate-return borrowers. Additionally, since many P2P lending sites are public companies, you can purchase their stock.
5. What occurs if borrowers delay or fail to make payments?
Ans: In the event of a default, additional penal interest will be applied to the due amount for the duration of the delay, which the borrower(s) will be required to pay directly to their lender (s).
