Peer to Peer (P2P) Lending – How you can earn upwards of 15% returns per annum?
Banks take our money as a fixed deposit, lend it to borrowers looking for funds as personal loans, credit card products etc and keep the lion’s share of the profit themselves, passing back very little interest income to us as investors (Only 6-7% FD interest rates). Peer to Peer lending through platforms like Monexo and others changes this by removing the bank from the lending equation. There are several investment options in India that provide higher returns. Peer to Peer lending (“P2P lending”) is one of them. It is a new-age alternative fixed income investment avenue regulated by RBI (“P2P lending”). In P2P lending, individual borrowers and retail investors (termed lenders) are directly connected through an online P2P lending platform completely eliminating the bank. P2P as an investment option provides higher returns than traditional fixed income products& monthly returns. What is P2P Lending all about? How does this Peer to Peer Lending work? What are the risks involved in P2P lending and what how you can mitigate them?
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What is Peer to Peer (P2P) Lending and how does it work?
Peer to Peer lending (P2P lending) has emerged as an alternative fixed-income investment for investors who are looking for higher interest income, portfolio diversification and the stability of monthly, recurring cash flows.
In P2P lending, individual borrowers and investors (called as lenders here in P2P) are directly connected through an online P2P lending platform completely eliminating the bank. Typically, individual salaried class borrowers in need of a small ticket, personal loan apply online to the P2P lending platform and the platform assesses for their repayment capacity. Eligible loans of screened borrowers are listed on the P2P platform’s online marketplace and investors can invest in small fractions of each borrower’s loan, earn monthly repayments and build a portfolio of loans – just like a bank!
Interest rates for the borrower are fixed by the P2P lending platform and since these loans are unsecured, the interest rates typically vary from 13% – 24% per annum on an average. Transactions are fully operationalised through a secure Escrow account and investors receive monthly repayments from borrowers in the form of ‘EMIs’.
Borrowers get access to inclusive, affordable credit in the form of personal loans digitally while investors fund these by lending out their surplus to eligible, creditworthy borrowers of their choice.
P2P lending platforms earn by only charging a small fee to both the investor and the borrower.
Is P2P Lending Legal in India?
The Peer to Peer lending industry originated in the UK in 2005 and in a short span of time is already a 150 – 200 billion dollar industry. US and UK are very large markets for P2P lending and platforms in these markets are emerging as a serious challenge to traditional banking due to superior technology, customer Centricity and ability to scale based on network effects.
In India, P2P lending, while it is fairly nascent is already seeing good traction among both retail borrowers and investors, which has resulted in the RBI regulating the section recognizing P2P lending platforms as a ‘new class of NBFCs’.
RBI regulated P2P lending in India in 2017 and there are more than 10 RBI recognized P2P lending platforms presently in India. As per RBI guidelines, an investor can invest a maximum of INR 50 lacs in P2P lending.
Why should retail borrowers approach a Peer to Peer lending platform for loans?
Peer to Peer lending’s target borrower segment is the urban, digitally savvy consumer who is creditworthy yet is underserved as far as access to credit is concerned from traditional banking channels.
In consumer lending, over the years, while demand for credit / loans has only grown – banks have become rigid and failed to distribute credits equitably to all – their traditional model of assessing risk has automatically excluded several creditworthy borrowers.
Their tendency to focus only on ‘top of the pyramid’ customers has resulted in an over-reliance on outdated credit appraisal methods which have not kept pace with customer aspirations.
P2P lending platforms like Monexo use smarter credit decision and dynamic risk scoring algorithms to identify, price and ascertain an individual’s capacity to repay over a period of time.
While banks have historically relied only on an individual’s credit bureau score, P2P lending platforms screen borrowers across a host of other credit parameters as well such as – recent bank data / transaction history, behavioural trends etc and as a result, these platforms are able to facilitate loans to a wider pool of borrowers – including those who traditional banking credit systems incorrectly classify as ‘risky’ borrowers but are actually safe to lend to as well as exclude those who may on paper seem ‘safe’ but are actually more susceptible to default.
Borrowers too are looking for digital, ‘on the go’ access to credit which banks have been unable to provide. P2P platforms, by cutting out the bank and pioneering newer, more efficient ways to understand credit risk of individual borrowers are able to provide them with expanded access to finance through a 100% digital process.
Key advantages for investors in P2P lending
(i) P2P offers high, risk adjusted interest income– nearly 2.5 times higher than Bank FD.
(ii) Stable monthly returns.
(iii) Large diversification across multiple borrowers.
(iv) Flexibility to choose borrowers.
V) Opportunity to exit early.
What are the risks in Peer to Peer lending?
P2P lending is not a guaranteed return product like a Bank Fixed deposit. Like other fixed income instruments involving credit risk, the main risk in P2P lending which investors need to be aware of is the default risk from borrowers.
Though platforms take plenty of efforts to curate and list only borrowers with a demonstrated ability to repay over a period of time, there is always a likelihood that one / few borrowers may not be able to service repayment of the amount lent to them by investors.
While default risk in P2P lending surely needs to be recognized and only investors with a moderate risk appetite should participate, there are multiple ways in which this risk can be efficiently mitigated and reduced as well.
How to do risk mitigation in Peer to Peer lending?
(i) Yield spreads / Diversification provides a sufficient buffer against borrower default
When you invest in a Corporate Fixed Deposit for instance, while surely highly rated corporates are extremely unlikely to default, if such an instance was to unfold typically depositors stand to lose the entire principal + interest they may have invested.
However, in P2P lending, since investors have diversified their investment across hundreds of borrowers, unless a majority / significant number of borrowers in their portfolio default, investors are unlikely to be negatively impacted by scenarios such as loss of principal or erosion of significant components of their interest income. P2P platforms argue, that given the stringent checks performed in assessing borrowers prior to bringing them to the platform, such large scale, systemic default scenarios are unlikely to occur.
Moreover, since the average interest rate of lending is around 18% per annum, the yield spread is large and can absorb borrower defaults – provided the investor’s portfolio is diversified across multiple borrowers.
(ii) Borrowers pay a high penalty for delayed repayments:
Any delayed payment would mean large additional costs for borrowers – such as penal fees, etc. These penalties enable P2P platforms to build repayment discipline amongst borrowers
In addition, borrowers also run the risk of their credit scores being downgraded as the P2P platforms reports non-payment of due to credit bureaus like CIBIL. Hence, non-payment to the P2P platform would mean borrowers would not be able to access loans from any other bank / NBFC in future. This is a powerful deterrent.
(iii) All borrowers sign legal agreements with investors & the P2P platform:
Every loan funded by an investor to a borrower on a P2P platform is backed by valid legal agreements. Hence, prolonged delayed payments / defaults (that is, nonpayment for a period of over 90 days) would mean borrowers are at the risk of legal proceedings being initiated against them by the P2P platform
(iv) P2P platform is responsible for recovery / collection:
In case of any delayed payments from borrowers, P2P platforms like Monexo proactively pursue the borrower to collect the delayed payments. This additional support to investors is extremely crucial and platforms like Monexo do not charge investors anything additional for this service. As an investor, you need not get involved in this process at all and the platform takes care of the entire follow up process.
(v) P2P platforms are invested in protecting investors against default:
A P2P platform, by its inherent nature works on demand-supply economics. It cannot increase business volumes/build scale unless it builds trust with its investors and provides them access to consistent returns with minimal default.
Hence, since the success of the P2P platform is ultimately tied to their ability to diligently curate qualified borrowers and ensures investor return expectations are met, P2P platforms are naturally inclined to work to ensure that the risk-reward equation is firmly in favor of the investor.
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What Precautions you should take before you invest in P2P Lending?
(i) Choose your P2P lending platform carefully – check whether your P2P platform meets the following requirements
o Whether the P2P platform is licensed by RBI
o Understand the P2P platform’s target borrower segment. Salaried borrower segment is much safer compared to other borrower segments
o Understand how the platform screens its borrowers – does the platform physically meet it’s borrower prior to loan sanctioning etc?
o Does the platform have skin in the game – does it earn fees upfront from investors or does it earn only once it’s investors start receiving repayments
o Number of existing borrowers and investors on the P2P platform
o Management background – prior experience in banking and technology is important
o Check whether the P2P platform provides collection and recovery support in case of payment delays
o Availability of Escrow account, flexible withdrawal / payout options
o Availability of niche features like Secondary Market for ‘early exit’ (Platforms like Monexo have this option for investors who invest > INR 5 lacs.
In net summary, invest in some of the best P2P Lending Platforms in India.
(ii) Diversify, diversify, diversify:
Diversification is the holy grail of P2P lending. It is strongly recommended that you do not lend more than 1% of your total amount you invest in P2P to any single borrower. Try to build a minimum portfolio of 100 loans.
(iii) Have a minimum investment horizon of 36 months:
Most of the loans you will be investing in through P2P lending platforms will have a duration of 36 months. While you will also find shorter term loans, most loans you will end up investing in would be for a duration of 36 months.
(iv) Invest not more than 10% of your overall investment portfolio in P2P
P2P lending is for investors with some risk appetite who have already built their core portfolio and are looking to diversify for additional interest income.
Hence, it is always advisable to not park more than 10% of your total portfolio in P2P lending. P2P lending can be strategically positioned as part of your fixed income portfolio to improve overall returns and provide monthly cash flow.
With a large projected upsurge in credit and demand for retail loans only set to increase , investors have an exciting opportunity to get an early mover advantage and invest in an alternative, retail asset class that drives domestic growth and consumption.
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The above article is a guest post from Monexo India. Monexo is one of India’s largest, RBI approved Peer to Peer lending platforms which is changing how people invest and borrow. Open an investor account with Monexo.
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Hi Suresh,
Are there any P2P lending platform (legal and following RBI guidelines) that allow investing small amount like Rs.5000 to start with?
Hi Amit, good to connect. Upfront disclosure – I look after Investor Sales at Monexo. There are a few other P2P platforms which do allow you to start with very small amounts. You will be able to google and figure this out. Having personally overseen over 3000 investor portfolios at Monexo, the rationale for fixing our entry intry into this product at INR 1 lac is as follows :
a) One cannot test the waters in P2P with micro investment amounts as the whole premise / value proposition as far as risk mitigation is concerned is the distribution of risk through diversification. An investment across five or six borrowers is not what P2P is about and hence to effectively protect downside, a minimum portfolio of atleast 50 – 100 loans is necessary. Hence, to achieve this level of diversification – a reasonable initial investment ticket size is required. If you invest 5K for instance and diversify across 5 five borrowers, and even if one defaults over a period of time – you are straight looking at 20% default run rate – which could wipe out your returns. On the other side, if you bring in INR 1 lac and invest in units of Rs 1000 across 100 or more borrowers – this diversification would provide solid buffer to your portfolio and ensure that you have peace of mind as an investor even with a % of non-payers in your portfolio.
At Monexo, we go all out to curate only borrowers who are creditworthy – they are credit assessed across 130+ parameters and we meet each borrower in person. Despite this and a strong recovery infrastructure, a few loans will go bad (that’s just the nature of consumer loans)- achieving zero NPA is not practically possible. But with diversification, the risk-reward equation is always in favour of the investor.
b) P2P is a product only for investors who have already built their safety net / core portfolio. Hence, we did not want to attract investors who have not yet built their basic savings kitty into this asset class – consciously. P2P works best for investors who have sufficient liquidity to invest into an alternative asset class, are looking to diversify and generate regular, monthly income.
I would be personally available to help you and other investors navigate P2P and the investment process at Monexo. Please feel to write to me on kevin.samuel@monexo.co for any queries.