Understanding p2p lending

There’s a lot of talk about p2p lending these days. So we thought we could see what the fuss is all about

The Story

Peer-to-peer lending or p2p lending is an alternative financing arrangement.

Most people, when short of funds, will probably turn to a bank. They’ll want to avail a personal loan at an affordable interest rate. Unfortunately, that avenue may not always be accessible. The paperwork involved, the processing time, the risk profile — everything has to be on point. And if you’re in a tight spot, all this back and forth might just aggravate your predicament. So you may want to pursue other alternatives.

Alternatives like p2p lending.

With p2p you no longer have to be at the mercy of a bank or other similar financial institutions. Instead, you can raise money from a fellow lender who may be looking to earn a decent return on their investment (something better than FDs). And if both parties were to visit an intermediary — a p2p lending platform, here’s what would happen.

First, you’ll be asked to divulge your credit history. The p2p platform will want to know for certain that you’re not a serial defaulter. And once they run their risk assessment algorithms on all your past borrowings, they’ll have a decent idea of how likely you are to repay any loan. They may even assign you a grade or a risk score — thereby letting everyone on the platform know, the kind of risk they may be dabbling with when lending to you. Once they’re through with this and you’re deemed eligible to participate, you can list your requirement — The kind of money you need, the interest you’re willing to pay, and the duration.

On the other side of the spectrum, they’ll onboard people who may be looking to invest in alternative avenues. At this point you may wonder, how is this an investment opportunity when it’s just people lending money to other individuals. How can you brand it differently, when we all know it’s just a loan?

Well, the thing is — Most p2p platforms will tell you that the nature of the financing arrangement hardly matters when you’ll be looking to earn a return on your investment. They’ll tell you that it doesn’t matter if it’s interest income so long as you make money off of it. And they will market this aspect during every opportunity they find.

They’ll even talk about the attractive returns you could earn here — which could be as high as 14% sometimes. And they’ll offer you the opportunity to customize your investment i.e. You could choose to lend to a single individual. Or you could lend to multiple individuals with different risk profiles. You could even use the help of the platform to automate your investment. So even if you don’t want to manually pick each profile, you still have the opportunity to build a loan book involving multiple people.

In the meantime, P2P platforms may charge a fee from both parties. Or in some cases, just the borrowers — because they’re the ones desperate to use the service. And if everything goes through, the borrower will raise all the money they need. They’ll promptly pay back the principal with interest and the lenders may end up earning 12–14% without much hassle.

Unfortunately, things can go awry very quickly.

You walk in thinking you’re picking a moderately risky individual but it’s very hard to know what a moderately risky individual truly is. By all accounts, if the individual defaults, your principal is at risk. There’s no collateral here. On most occasions, you don’t even have a real recourse. The p2p lending platform may serve a notice on your behalf, but the ultimate liability is on you. And it’s only when people fail to repay, do you finally realize this bit.

p2p platforms are undoubtedly useful. But if you’re dabbling with this thing thinking it’s an easy way to make 12–14%. Well, we have news for you — You’re risking capital every time you put up money here. And for people who don’t have a lot of money to spare, this might not be the most prudent thing to do.

Preserve capital. Build an emergency fund. And when you have a sizeable saving corpus, maybe you could think about allocating a small part of your portfolio to p2p “investments.”

Until then…

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