What is Peer-to-Peer (P2P) Lending?
Peer-to-peer lending, also referred to as P2P lending, is an alternative financing method which allows individuals to avail loans from other individuals through online lending platforms. Through these platforms, borrowers who seek unsecured personal loans can get in touch with investors who are willing to lend to them with the intention of earning a higher return on their investments. The P2P lending platforms let investors go through a list of verified borrowers and their details before they lend to them.
Lenders can diversify their investments by lending to multiple borrowers in small amounts. Also known as crowdfunding or social lending, P2P lending is gradually gaining popularity among borrowers and investors in India. P2P platforms are regulated by RBI.
Features of Peer to Peer Lending
- P2P lending system raises loans for individuals who don’t have access to traditional banking systems from persons who want to invest their money.
- By eliminating the need for a banking system or a financial intermediary in the borrowing and lending process, it extends credit to individuals who can’t avail it through financial organisations.
- The main principle of this system is to offer benefits to the borrowers as well as the investors. While it facilitates people to borrow funds in low-interest rates, it also enables savers to earn a good interest on their saved amount.
- The entire process is conducted through online platforms where both the lenders and the borrowers register themselves and directly get connected with each other. Only after doing a proper assessment, the members can participate in the transactions.
- All peer-to-peer lending platforms are regulated by the Reserve Bank of India.
How does peer-to-peer lending work?
Peer-to-peer lending is a fairly straightforward process. All the transactions are carried out through a specialized online platform. The steps below describe the general P2P lending process:
- A potential borrower interested in obtaining a loan completes an online application on the peer-to-peer lending platform.
- The platform assesses the application and determines the risk and credit rating of the applicant. Then, the applicant is assigned with the appropriate interest rate.
- When the application is approved, the applicant receives the available options from the investors based on his credit rating and assigned interest rates.
- The applicant can evaluate the suggested options and choose one of them.
- The applicant is responsible for paying periodic (usually monthly) interest & principal payments or pay interest periodically and repaying the principal amount at maturity.
The company that maintains the online platform charges a fee for both borrowers and investors for the provided services.
Advantages and disadvantages of peer-to-peer lending
Peer-to-peer lending provides some significant advantages to both borrowers and lenders:
- Higher returns to the investors: P2P lending generally provides higher returns to the investors relative to other types of debt investments.
- More accessible source of funding: For some borrowers, peer-to-peer lending is a more accessible source of funding than conventional loans from financial institutions. This may be caused by the low credit rating of the borrower or atypical purpose of the loan.
- Lower interest rates: P2P loans usually come with lower interest rates because of the greater competition between lenders and lower origination fees.
- Diversification: Lender can choose to lend his/her funds to many borrowers and thus limit the risk by diversification.
- Legislation: In India all P2P platforms are regulated by RBI. But regulation of platform DONOT guarantee the safety of loan given to borrowers in any manner.
Nevertheless, peer-to-peer lending comes with a few disadvantages:
- Credit risk: Peer-to-peer loans are exposed to high credit risks. Many borrowers who apply for P2P loans possess low credit ratings that do not allow them to obtain a conventional loan from a bank. Therefore, a lender should be aware of the default probability of his/her counterparty.
- No insurance/government protection: The government does not provide insurance or any form of protection to the lenders in case of the borrower’s default.
- High Risk: As the adage goes “Higher the returns, higher the risks.” Same is true with this product also. It is a high risk investment product, so one must have full knowledge before lending to others through P2P lending platforms.
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