Technology has taken an important place in our lives. It has made many things simpler. Be it shopping, communication, education, or information- everything is just a few clicks away.
Technology is playing a big role in the field of finance as well. Various tech innovations like- blockchain, artificial intelligence, machine learning, automation, etc. are bringing the fintech revolution to India.
In this scenario, a number of startups are coming up with new business models in terms of Fintech Platforms, across different segments. Peer to Peer Lending is one such platform. (Also Read: Alternative Investment Funds- to participate in the startup growth story)
It is a platform that connects a person who needs money (borrower) and a person who has the money and wants to invest (lender). The investor may choose whom to lend money and the borrower may get funds from multiple lenders.
In this article, we will see how peer to peer lending works, its pros and cons, is P2P lending safe, and should you go for this alternative way of borrowing and investing? Let’s start with the basics first.
What is Peer to Peer Lending?
Peer to Peer Lending, or as it is known as P2P lending is an online platform (or you may say online marketplace) where people can directly borrow and lend money to individuals and small businesses without the involvement of any financial institution like- Bank or an NBFC.
The loans disbursed through these platforms are unsecured and a majority of the borrowers are those who do not get loans through the traditional mechanism. The duration of the loan is a few days to a few months, usually taken for consumption purposes, emergency requirements, or to repay any existing loan like- credit card bills, etc. The ticket size of the loans is low as well. (Also Read: How to use credit cards wisely)
Loans are easily available on P2P Platforms. There are fewer formalities as compared to the Banks or NBFCs and the disbursal process is less time-consuming as well.
Some Peer to Peer lending platforms in India includes- Faircent, Lenden club, Liquiloans, Monexo, etc. Recently (in Aug. 2021), two popular fintech start-ups Cred and Bharat Pe also launched their P2P platforms.
Peer to Peer Lending: RBI Regulations
The Reserve Bank of India (RBI) regulates the functioning of these P2P platforms through its NBFC- Peer to Peer Lending Platform Directions, 2017. Under this, it has been mandated that all P2P lending platforms (both existing and new launches) to get registered as an NBFC-P2P with the RBI and should have a net worth of at least Rs. 2 Crores. The outside liabilities cannot be more than twice the assets owned.
All platforms have to follow certain guidelines regarding lending, borrowing, and operational requirements, as stated in the RBI Directions. Prominent among them are listed as below:
- A lender across all P2P Platforms, cannot lend more than Rs. 50 Lakhs and that to a particular borrower, Rs. 50,000. However, if the overall exposure exceeds Rs. 10 Lakhs, then the lender has to submit a CA certificate of net worth more than Rs. 50 lakhs, to the P2P Platform.
- The maximum amount a borrower is eligible to borrow is Rs. 10 lakhs and the maturity of the loans cannot exceed 36 months.
- The platform cannot use its own funds for borrowing or lending and cannot guarantee any assured return on investments to the lender.
- Transfer of Funds between the lender and the borrower will happen through escrow accounts, the control of which will be in the hands of a third-party trustee bank. It is done to promote transparency of affairs and avoid the conflict of interest of the P2P platform. The mechanism is described here.
How Peer to Peer Lending works?
For the Borrower
If you want to borrow funds from the peer to peer lending platform, you need to register on the platform by filling up an online form and paying the registration fees (non-refundable). You need to upload certain identity documents like- PAN, Aadhar, Passport, etc. In addition, salary slips, ITR copies, bank statements, etc. would also be required for profile evaluation.
Based on the data provided, the P2P Platform verifies the identity, checks the creditworthiness by sharing your data with a Credit Information Company like CIBIL, and evaluates your risk profile as well. It is done to check your efficiency to repay the loan.
Apart from this, the platform does apply some other internal checks and balances as well. For instance, your personal habits, app usage, social media activity, etc.
If your profile is approved, the loan gets listed on the platform. The interest rate of the loan varies from a case-to-case basis, depending upon the levels of checks and balances you have qualified. Usually, it ranges between 10-30%.
The platform also helps segregate the borrowers by putting in different risk buckets as per their credit rating and profile evaluation.
For the Lender
If you want to lend (invest) money on the peer to peer lending platform, just like the borrower, you would have to get yourself registered on the P2P platform by providing some details, the required documentation, and the registration fees. The platform will verify your profile too and if approved, you may start lending by signing into your account.
You would now be shown various loan options along with personal and financial details of the borrowers, whom you may choose to lend money to one or multiple borrowers as per your risk appetite. The platform also gives you the option to filter the borrower based on various criteria like- location, income, nature of the job, etc. Once the requirement of the lender and borrower match, the loan reaches the funding stage.
Before the loan disbursal takes place, you need to sign an agreement with the borrower, facilitated by the platform. It includes all the terms and conditions of the deal and it is advisable to read it thoroughly before signing. Once signed, it becomes legally binding on both the borrower and the lender.
Peer to Peer Lending: Advantages and Disadvantages
Peer to Peer lending is an alternative mechanism for borrowing money. It can also serve as an alternative investment vehicle to bank deposits and debt mutual funds for those who want to invest.
Advantages for the Borrower
- RBI Regulated.
- Availability of loan, even with a low credit score and lower disposable income.
- Faster and flexible loan processing as compared to banks or NBFCs.
- Loans are unsecured, so no collateral is required.
Disadvantages for the Borrower
- Interest rates are somewhat higher than Banks and NBFCs. It can increase significantly if the profile is low.
- The platform may demand various personal information which may lead to privacy issues.
- The platform charges processing fees as a percentage of loan amount, along with the fixed fee. It may range from 5-10%. Lower the loan amount, higher would be the fees. Also, if you wish to prepay the loan, you need to bear some additional charges. (Source: Faircent website), these charges may vary from platform to platform.
- The P2P platform can go to any extent to recover the loan, in the event of any defaults. Penal interest as high as 18% p.a. would be charged, if the EMI is delayed. In extreme cases, legal notices can also be sent.
Advantages for the Lender
- Lenders can start investing with small amounts. Some Peer to Peer lending platforms allow investment with as low as Rs.5,000.
- Lenders may earn higher returns on their investment than the traditional investments, like Bank Fixed Deposits, Small Saving Schemes, Debt Mutual Funds, Bonds, etc.
- Lenders have the flexibility to filter and choose the borrowers to whom they want to lend, as per the risk appetite.
Disadvantages for the Lender
- Lenders also have to pay hefty fees to the platform. Along with the fixed fee, the P2P Platform also charges transaction fees as well. In addition, any expenses on legal proceedings and other recovery efforts done by the lending platform, in the event of default by the borrower, shall be borne by the lender. (Source: Faircent website), these charges may vary from platform to platform.
- The returns are not guaranteed and RBI doesn’t provide any insurance on the deposits made on these platforms. (Also Read: How much of your bank deposits are insured?)
- The rate of defaults is much higher in a majority of these peer to peer lending platforms. The average default rate is somewhere between 2-7%, which is a considerable portion. It means that even after the due diligence carried out by the P2P platform, the credit risk is much higher. It may not only impact your returns but also put the capital at risk as well.
- The lender may not be in a position or lack the expertise of creating a diversified lending portfolio, which may increase the risk even further.
Tax implications on returns for lenders (investors):
The interest income received through investments in the Peer to Peer Lending platforms is taxable under the head ‘Income from Other Sources’. The tax would be deducted as per the income tax slab rate applicable. For example, if your gross return from the P2P platforms is 15% and you fall in the 30% tax bracket, the post-tax yield would come around 10.50%.
Tax is implied when the interest is actually credited to your bank account. Unlike Bank interest, no TDS is deducted on this interest income by the lending platform. You have to self-assess the interest income and pay tax accordingly. (Also Read: How to avoid TDS on Bank Interest?)
Is Peer to Peer lending safe- Should you go for it?
Well, frankly speaking, NO. Peer to Peer lending is not at all safe, at least from the investment perspective. I don’t know whether it should even be called an ‘investment’. It is just a medium through which unsecured loans are disbursed to people with low income and credit profiles, who cannot get loans from the traditional mechanism and the lender earns some interest on the same. (Also Read: Are loans available to people with no credit history?)
The nature of the loan and the profile it caters to is enough to gauge the level of risks involved. Some P2P platforms claim double-digit returns on the loans. But, it needs to be understood that higher returns come with higher risks as well. As explained above, the credit risk is very significant, despite all the checks and balances carried out by the P2P platform. (Also Read: Types of Risks and how to manage them)
Not only borrower defaults, in some cases, it is also seen that the platform itself has gone bust and shut shop, or may have to close down the operations due to RBI regulations. It puts your money at an even deeper risk. It might be a possibility that you may never get your money back.
Although RBI is regulating this space, there are also chances of frauds happening on these platforms. It happened in China on a massive scale, a lot of people lost huge sums of money. Please refer to this link for details.
In India too some unregulated platforms are caught in fraud cases. This Hindu Business Line Article explains the issue.
Also, peer to peer lending platforms can be avoided from the borrowing perspective as well. You should not fall for the easy availability of credit and borrow for each and every need, that too at high-interest rates. (Also Read: The Good and the Bad Loans)
It is a more common phenomenon among millennials, nowadays. It can have serious repercussions on your financial life going forward. For instance, late payments or defaults on these loans may ruin your credit score and you may not get a loan when you are in genuine need. (Also Read: 21 Financial Mistakes you should avoid)
It is always a better idea to save first and then spend and keep the basic principles of financial planning in place, like- keeping an emergency fund, budgeting for needs, wants, and desires, etc. (Also Read: Financial Planning tips for beginners)