The P2P Primer
One of the leading trends within the credit industry in the recent past is that of Peer To Peer Lending, popularly known as P2P lending. As a mechanism P2P lending is advertised to provide lenders and borrowers an alternative to commercial banks when looking to meet their needs to provide and procure capital for various needs. P2P lending is therefore gaining popularity among a vast majority of individuals. But, before we consider P2P lending as a viable option worth dabbling in we must first understand everything about the way the mechanism is designed, the pros and cons involved with the way it works and thereby decide whom P2P lending is most well suited to. Therefore in today's blog post I will be covering all the aspects mentioned above with regard to P2P lending so that it serves as a foundation or primer for those of us who wish try their hand at P2P lending, either as a lender or as a borrower.
Let us begin by understanding how the essential mechanism of P2P lending works. There is a lender who is looking to provide capital at a certain rate of interest, a borrower looking to procure those funds and a P2P lending platform that brings the two parties together and acts as an intermediary between them. The borrower and lender may approach the P2P platform with the relevant documents required for the transaction and get the transaction executed in exchange for paying the applicable fees and charges to the lending platform. The P2P platform then arranges for the loan to be disbursed in collaboration with a partner bank. The partner bank handles the actual disbursement of the loan to the borrowing party. This can be understood looking at the graphic below.
The way in which a P2P lending transaction works is in stark contrast to lending to or borrowing from a bank. When an individual opens a deposit account with a commercial bank, the bank accepts the deposit and lends the money out to individuals who meet a list of eligibility criteria set by the bank. Banks lend at a higher interest rate compared to the rate of interest they offer on deposits. This difference in rates is known as the spread, which is usually in the rate of 4-5%. A part of this spread is retained by the bank to serve as the bank's profits. But it can also be argued that without the interest rate spread, lenders could have earned a higher rate of interest on their deposits. And this is the biggest advantage that P2P lending offers, from the perspective of the lender. Because a P2P platform is not a commercial bank as such, there is no question of an interest rate spread. Therefore, lenders can provide capital at higher rates of interest, say in the range of 10-15%. From a borrower's perspective, the fact that a P2P platform is not a bank means that the criteria to procure capital would be relatively less stringent. Also, borrowers would not have to bring a collateral into a lending transaction being routed through a P2P platform. This is because it is mandated that P2P platforms cannot demand collateral securities from borrowers. And finally, borrowers would not be subjected to the usurious and coercive methods sometimes employed by commercial banks in the case of non payment of dues.
But, working with P2P platforms also comes with its own set of drawbacks. Firstly, although P2P platforms are currently regulated by the RBI through the Master Directions for NBFC Peer to Peer Lending Platforms 2017, these regulations are still skeletal in nature and need a lot of refinement and sharpening. Therefore, participants would have little to no recourse of note if things go wrong over the course a transaction. Also, because loans may be extended at higher interest rates through P2P platforms, borrowers may find it harder to repay their loans on time. This would automatically affect their credit scores, making it more difficult for them to secure further credit in the future.
But it is the lenders who are exposed to the worst of the drawbacks when providing capital through P2P platforms. Firstly, unlike a commercial bank which stands as a guarantor for the lender's money when accepting deposits and extending loans, a P2P platform usually does no such thing. Therefore, the safety of the lender's money would always be under question. Also, the fact that borrowers are not required to bring in a collateral to a P2P transaction means that the lender only has the credit worthiness of the borrower to fall back on over the course of a P2P lending transaction. Moreover, in a P2P lending transaction the lender's upside would be capped, without any such cushion on the downside. For example, if I lend a certain sum of money through a P2P platform at say 10%, the maximum I can make on my investment is the 10% interest over the tenure of the loan. But if things were to go wrong, I would stand to lose all the money I have extended as part of the transaction, with close to non existent legal recourse available. And finally, the rate of defaulting borrowers in P2P lending transactions can be quite high (as high as 30% in fact). And this presents quite an unsavory prospect for lenders. For example, let us say I lend Rs 1,000 each to 10 borrowers at 10% (total advances Rs 10,000). Assume that 3 of these 10 borrowers default on the entire amount of their loans (default rate of 30%). Therefore, my good debts would amount only to Rs 7,000. Now, a 10% return on Rs 7,000 would be just Rs 700 and not the Rs 1000 I had expected on my total advances of Rs 10,000. In fact to get back the original Rs 10,000 I had lent out, I would have to charge interest at as high as 42.85% on my good loans worth Rs 7,000. And that would not be practically feasible for any lender or borrower to honour. A quick overview of the pros and cons of P2P lending have been given in the graphic below.
This just leaves the question as to who among us should consider lending through and borrowing from P2P platforms. As far as lending is concerned, those among us who have more than enough money to spare can consider lending limited amounts through P2P platforms. Also, those of us who are well acquainted to people who are in need of money and have a spotless credit history can look at P2P transactions as an option. Those looking to borrow from P2P platforms must ensure that they have a robust credit history backing them. They must also ensure that they do not take on significant amounts of debt from P2P platforms. Finally, they must ensure that they negotiate a reasonable interest rate on any debts they raise from P2P platforms. The overriding conclusion from here should be that even with their clearly evident benefits, P2P lending transactions are still a fairly new concept. And while P2P platforms are regulated to a certain extent, a lot more regulatory and technical evolution is required before we can start taking P2P lending seriously. Therefore, those of us looking to participate in P2P transactions must take time to think things through and make well informed decisions rather than impulsive and reactionary ones.