P2P lending has been around for quite some time in developed markets. In India this form of lending / investing has started making inroads only recently after RBI has started to regulate this form of lending business. As the word ‘Peer to Peer’ or P2P denotes, this form of lending business results in a Person (investor) giving out loan directly to a borrower. To facilitate the lending activity, a Fintech platform would end up working as an intermediary who would take the end to end administrative, regulatory and risk management processes associated with the lending business. P2P lending platforms are required to be registered with RBI to promote standardization of their processes along with ensuring that they adhere to minimum regulatory standards of risk management and capital safety.
To understand P2P lending framework better, it would be helpful to see its closest sibling, a banking / finance company’s operations and business model :
- Banks take deposits, be it in the form of an interesting bearing account such as Fixed Deposit, Savings account, or a Current Account. This forms the pool of money which the banks use to lend to the borrowers.
- Banks give out loans, catering to various forms of demand such as a Housing loan (mortgage), business term loans, vehicle loans, overdrafts, personal loans etc. These loans could be a secured loan or an unsecured loan. Banks charge an interest to the borrowers which vary with the type of loan, security offered on the loan and the credit worthiness of the borrower. The thumb rule behind the interest rate being, higher the risk of loan not being repaid, higher would be the rate of interest charged on the loan.
How do the banks make money ?
The business model of a bank is relatively simple. They earn interest on the loans given to borrowers and their costs is primarily the the interest they pay on the money taken from the deposit / account holders. The differential between interest earned and interest paid is their income. In the process of lending, they also end up having losses whereby some of the borrowers do not pay back their loans – partially or fully. While the banks put in significant efforts to collect the dues from the defaulters, but it is reality that there will always be a certain percentage of the borrowers who will not fully pay back the loan, hence the credit losses. The only thing which comes to the protection of the banks are their risk management standards to shortlist their borrowers and the amount of funds they loan out to borrowers after assessing their credit worthiness.
Can I be a Lender ?
If the business of banks make sense to a person, they would intend to consider – why shouldn’t I start lending. There are broadly few ways to do so :
- Buy equity shares of a listed bank or a finance Company from the stock market. A shareholder is technically a part owner of the business and hence one can get to share the earnings of the bank which will be reflected in the share price and regular dividends paid by the Company. However, this may not appease many people as they would not like the daily ups and down of the share prices.
- Lend to people you know at agreed interest rates.
- Lend via a Peer to Peer (P2P) lending platform
How Does a P2P Platform Work ?
To best understand the operational activities within a P2P platform, let us take an example of a lender who intends to start his P2P lending journey.
- After registering on the P2P platform with necessary ID, address and bank proof, the lender is all set to start lending (investing) his funds to potential borrowers.
- One does not need a huge amount of Capital to initiate their lending journey via P2P. The minimum ticket size set by a P2P Company can vary, but generally it ends up being within INR 50,000 to INR 100,000. The low minimum threshold helps in making a start and building lending conviction via this relatively newer avenue.
- The P2P Company sources the borrowers via multiple channels. Examples could include partnering with say an Auto dealership where vehicle loans could be provided via P2P or direct borrower requests.
- Not all borrowers get shortlisted by the P2P Company as the borrowers need to go through a series of minimum risk management checks such as minimum salary threshold, amount of existing loans (leverage) with the borrower, CIBIL credit score, stabilty of source of income, etc. All such checks are aimed to avoid high risk borrowers who may not be able to repay the loan or have a fraudulent intent.
- Lender transfers the fund from his bank account to the escrow account of the P2P Company and can start lending funds via the website of P2P. There are a few interesting features of a P2P lending procedure :
- A lender cannot invest (lend) more than 10 lakhs in total per PAN. The limit has been further increased to 50 lakhs in 2020 by RBI. We believe the objective behind this maximum cap is to prevent inexperienced lenders (investors) from going overboard on a relatively newer investing vehicle.
- Maximum amount of loan which can be given to a single borrower by a lender is capped to Rs. 50,000 with a minimum individual loan amount at Rs. 1,000. This is one of the most flexible feature of P2P lending and is geared towards diversifying the loan portfolio of an investor. As a lender, you can give out loans in multiples of Rs. 1,000 each. Hence for a borrower who needs Rs. 1 lakh, he may be funded via multiple lenders whose minimum loan amount could range from Rs. 1000 per lender to max Rs. 50,000 per lender. In other words, this is similar to crowd funding concept. See the exhibit below where a borrower needs Rs. 30,000. There are multiple lenders who have contributed to make up to the loan of Rs. 30,000, with a minimum contribution of Rs. 1000.
- The borrower pays his EMIs on the due date to the P2P Company which in turn distributes it back to the borrowers in the proportion they contributed to the loan. For example, if you funded 1% of the Loan, you will get 1% of the monthly EMI credited to your account.
- The money loaned out is blocked for the duration of the loan, generally around 3 years. The primary return of your investment would be via the regular EMIs received on loans. Hence lenders must not consider allocating funds towards this option in case they need access to their funds in around 3 years.
Expected Returns out of P2P Lending
The returns out of a lending activity is directly related to the level of risk taken by the lender. Loans on P2P are mostly unsecured in nature, equivalent to a personal loan. An excellent credit rated borrower may end up paying around 8-9% interest and the interest rate for a not so good rated borrowers could go upto 21% and higher. Hence, at a portfolio level with a mix of different types of borrowers, the rate of return could be around 15%. One should also consider an expected default by the borrowers which depends upon the type of borrowers selected by the lender. For a moderate risky portfolio, the credit defaults could end up shaving ~2%-3% off the returns. However, the more granular one’s portfolio is, the lesser is a chance of a single borrower to make a material impact on the overall returns of the loan portfolio.
What if the Borrower Defaults
In an event of a delayed EMI or a default, the P2P Company jumps into action. The first action ends up reporting to the Credit Agency such as CIBIL, which will result in a negative impact on the credit score the borrower.
In the initial few weeks, there are regular followup calls done by the P2P Company followed by invoking the Credit Collection team to make a connect with the borrower and recover the overdue loan instalments. In most of the cases, delay gets regularized by the borrowers as they do not want to damage their credit history by defaulting upon a loan.
Where the borrower is still defaulting, P2P Company will invoke a legal action and file a recovery suit. This will also result in recording of a criminal action against the borrower. In many cases, it could permanently impact the borrower’s future career prospects as employers may not hire a person with a criminal record.
Once there is a recovery of funds, they are credited back to the lender account. In this whole process, no action is required to be done by the investor as it forms a key part of the P2P Company’s responsibility.
What is in it for the P2P Company
In return of the services performed by it, the Company charges a percentage fee on the EMIs it has collected from the borrowers and also a processing fees charged from the borrower at the time of disbursement of the loan. Generally it can range bettween 1% to 2.5% of the EMI amount. A summary of activities performed by P2P Company in return of this fees include :
- Sourcing borrowers, performing rigorous credit and KYC screening checks
- Maintaining a technology solution to connect borrowers with lenders
- Manage and maintain all legal documentation necessary for a loan contract;
- Disbursing of loans, collection of EMIs and allocation to the lending investors;
- Collection services and taking legal action against defaulters, including reporting back to CIBIL.
- Regular reporting back to lenders on the performance of their loan portfolios.
When one looks at the list of activities performed by a P2P Company, the fee could sound reasonable, but an effort must be made to select a P2P option which has its fees on the lower end of the spectrum.
What is in it for the Investors / Lenders
P2P lending solution adds as an additional investment avenue for investors to consider. We are summarizing the key Pros and Cons of this investment avenue.
Pros
- Provide an investment option in the form of a lending business with a relatively low amount of Capital, i.e. as low as Rs. 50,000.
- Granular risk management for lenders whereby they can spread their lending corpus across wide number of borrowers. In an event of a default by one or more borrowers, only the amount allocated to such a borrower gets impacted.
- All operational hassles associated with a lending activity are taken care of by the P2P Company. These activities include sourcing borrowers, collections, recovery, risk management, Compliance reporting.
- Returns on the loan portfolio may be able to match Equity returns at a portfolio level along with a regular stream of returns via the monthly EMIs.
- Enjoy power of compounding by investing back the EMIs into fresh loans.
Cons
- P2P loans are unsecured in nature and hence in case of a default, the lenders will have a limited recovery option (if any). The two primary ways to prevent and mitigate this risk is by having a granular portfolio and not getting skewed towards higher risk loans.
- The portfolio of loans are illiquid, i.e. a lender would not be able to access funds for the duration of loan, except by way of regular EMIs.
- From Taxation perpective, income from P2P lending, i.e. interest income will be taxed as per the tax slab of the individual. Hence for higher tax slab investors, this could be a material tax outflow from their lending income.
If you are interested in exploring this mode of investing, you can reach us via the contact us page for more understanding.