Awareness created by social media influencers and various financial institutions regarding different investment avenues during the pandemic led to a huge shift of money from traditional investment avenues like fixed deposit or post office schemes to stock markets. Ease of opening and operating various investment accounts made this shift much easier as the entire process was seamless.
Post pandemic, markets went on an upward rally and investors got convinced that the stock market was the place to get rich. Almost everyone forgot about the safety and stability provided by fixed income products in one’s portfolio. Even the influencers started talking all sorts of negative things about fixed deposits as an investment option.
Then came a small correction in the early months of 2022, suddenly the easy money coming in from stock markets stopped. People again realised the importance of having fixed income products in the portfolio to provide stability during adverse market conditions. But the interest rates offered by fixed deposits were too low for the public to invest in them and this made them look for other alternatives in the fixed income space.
In this post, we are going to talk about a product that was present even before the pandemic but has recently picked up due to awareness and better regulations. We are going to discuss Peer-to-Peer lending (P2P lending).
In a traditional world, if a person wants to borrow some money, he has to approach the bank and take a loan. Also if a person wants to invest money then he approaches the bank and makes a fixed deposit. So indirectly, the bank lends the money received from a person doing fixed deposit to a person who needs the loan. Banks take the difference between the FD rate and lending rate as profits for their business.
Example: A bank provides 6% on fixed deposit and lends money at 12% making a 6% profit. Peer-to-peer lending is a mechanism which connects people in need of loan with others willing to lend. The platform acts as an intermediary or marketplace that connects borrowers and lenders. A borrower has to register on the platform and a credit risk profiling is done in order to decide the lending rate for the borrower.
After the rate is decided, the loan requirement is uploaded on the platform and investors can invest in this loan opportunity. Platform will only charge a fee based on the EMI recoveries. This gives an investor the opportunity to cut the middle man (banks) and lend directly and earn a higher rate of return.
Advantages of a P2P platform
1) Higher rate of return: Based on the credit rating of the borrower on the platform, the interest rate could range from 8%-28%. This is much higher than a bank fixed deposit.
2) Lower ticket size: You can lend as low as Rs. 100 - Rs. 500 per borrower. So if you want to invest Rs. 1,00,000, you can distribute this into multiple small loans and reduce risk of defaults.
3) Automatic EMI recovery: Platforms register a standing instruction for auto debit of EMI in the borrower's bank account. Hence the EMI is automatically recovered and paid back to you.
4) Regulated: All P2P platforms come under the purview of RBI regulations. All players are required to register for a NBFC-P2P licence to provide P2P lending services.
5) Online process: Entire process is completely online and does not require any paperwork or branch visits. This provides convenience to borrowers as well as lenders as everything is online.
Disadvantages of P2P Platforms
1) Default risk: This is the biggest turn-off for P2P investors. If the borrower defaults on EMI payments then the entire risk is of the lender (investor). In the case of banks, a fixed deposit investor has no risk of capital because banks guarantee a fixed rate of interest.
However in P2P lending, the platform does not take any risk of default and the entire loss is to be borne by the lender. Platforms do have mechanisms to initiate recovery proceedings on the borrower however they are not as strong and stringent as banks.
2) Liquidity: Unlike fixed deposits, where an investor has the option to withdraw the money anytime by paying some nominal penal charges, in case of P2P lending, the investor has to wait till the entire duration of loan to recover the amounts in form of EMIs. There is no option to withdraw prematurely. Some platforms do offer an option to transfer your loans to other investors but the process is not easy or seamless.
3) Unsecured lending: P2P lending is a form of unsecured lending. It means that the borrower does not have to provide any security or collateral asset against the loan that can be sold off to recover the loan amount in case of default.
P2P lending is a very risky investment avenue. High interest rates of up to 28% sound attractive but risk attached to the high interest borrower is much higher. P2P lending in India is still at a very nascent stage and more regulations may come in future to make it safer for individual lenders. Keep in mind that P2P lending is not an alternative to bank fixed deposits.
CA Rohit J. Gyanchandani is Managing Director, Nandi Nivesh Private Limited, A Pune based Wealth Management Company.