We live in a fast-changing world. Innovative technologies and new trends are redefining the way we live our lives. Right from the way we buy products to the way we consume information, it is all evolving at a rapid pace. The investment landscape has not been left far behind either. With growing technology, fintechs started evolving in the last couple of decades. These platforms offer financial services as an end-to-end process using the internet. They are constantly bringing most financial transactions to our handheld devices making them more convenient and cost-effective. Peer to peer lending is one such alternative investment avenue available to you today. In this article, we will talk about some vital things that you must know about P2P lending before you start investing.
1. How does P2P Lending work?
P2P Lending platforms provide an opportunity for Retail Investors to lend funds to Retail Borrowers without the intervention of banks or other financial institutions. Both investors and borrowers register on the platform and after fulfilling some basic documentation requirements, start interacting with each other for loan requirements. Here is a quick glance at the entire process as offered by People Lend, a trusted name in P2P Lending:
Traditional lending-borrowing cycle
2. Risk Classification of Borrowers
Traditionally, banks and financial institutions relied heavily on credit scores (like CIBIL) to determine the loan eligibility of borrowers. Most P2P platforms look at a much broader picture. They take into consideration multiple factors like the location of residence, credit card history, trends in expenditure, income, etc. before assigning a risk class to the borrower. A borrower with a lower risk class usually has a range of lower rate of interest associated with his profile. This is because an assessment of his financials reveal that the chances of default for this borrower is low. On the other hand, a borrower with a higher risk class has a higher probability of default and has higher interest rates associated with his profile. Typically, P2P platforms divide the risk classification into five types, ranging from the least to the highest risk.
3. You can lend a partial amount
Most P2P platforms allow investors to lend a percentage of the amount sought by the borrower. So, if a borrower needs Rs.10 lakhs and you want to invest Rs. 50,000 – you can. The borrower will accumulate his funds from multiple investors and repay the monthly instalments to each of them.
Most investment experts recommend diversification as an important tool to earn good returns. With P2P lending, diversification is inherent to the way they have been designed. Once you login to a P2P platform as an investor, you can browse through all the loan requests raised by borrowers. You have the liberty to choose them as you deem fit.
Level I diversification: Based on your financial goals and risk preference, you choose an optimum mix of borrowers from different risk classes. It is akin to an equity and debt investment bundled together.
Level 2 diversification: Once you have decided on the percentage of each risk class in your portfolio, you can diversify further by selecting multiple borrowers from each risk class.
Here is an example:
You want to invest Rs. 100,000. After assessing your financial goals and risk preference, you come up with the following break-up:
Now, you look at the loan requests from each risk class and select as follows:
|Risk Class||Amount||Number of borrowers||Amount loaned to each borrower|
Hence, by lending Rs. 5,000 to each borrower you further hedge yourself against risks and create a balanced portfolio of investment.
5. Fees and Charges
There are different types of fees and charges associated with P2P lending like:
These can vary with different platforms and should be checked carefully before investing.
Peer to Peer lending is growing in popularity amongst both investors and borrowers since it is a quick and cost-effective alternative to lending and borrowing. Understanding these five aspects can help you get started with P2P lending. Remember to research and understand the market well before you start investing. Also, start with smaller amounts and increase them slowly as you go. If handled with due diligence, P2P lending can be a great addition to your investment portfolio.