With low yielding asset classes like fixed deposits, commodities and real estate losing their appeal, P2P lending is gradually emerging as an attractive ‘short term, debt investment’ for both retail and HNI investors.
In P2P lending, individual investors are able to become online lenders and earn attractive interest income by lending directly to individual borrowers who are sourced, screened and priced by the P2P platform. Salaried Borrowers look for short term, personal loans which are provided through the P2P platform and funded by individual investors who participate as lenders.
As a financial advisor, as you explore introduction of new products to your client base for portfolio diversification and better returns, it is only natural that you would want to do robust due-diligence on the product.
So, here is a quick five step guide on a few aspects of P2P lending which you may need to be aware of before you introduce the product to a client.
P2P lending is a regulated product
On October 4, 2017, RBI released the final regulatory framework for P2P lending in India – recognizing P2P platforms as a new class of NBFCs (“NBFC – P2P”). The regulatory approval is already having a huge impact on how potential investors perceive the asset class. Investors who lend money through P2P lending platforms now have the assurance of investing in a recognized asset class that is backed by a solid regulatory framework.
Risk mitigation in P2P lending
Though the loans offered by P2P platforms are unsecured, there are several ways to ensure that lending related risk is mitigated.
At Monexo, for instance, there are 6 different ways through which borrower default risk is mitigated of 1) Robust borrower screening inclusive of anti-fraud checks 2) Credit policy 3) Diversification of portfolio 4) Credit Bureau reporting 5) Insurance scheme to protect principal against event based risk and 6) Collections support
A borrower’s financial position, existing loan burden and repayment behavior are carefully analysed before the loan is listed on the P2P platform for the investors to lend to.
P2P platforms provide investors the ability to distribute their investment across multiple loans. An investment, as small as Rs. 1 lakh can be loaned out to nearly 100 different borrowers. As a result, risk of loss due to default, to a large extent is mitigated by ensuring that the loan portfolio is diversified.
Beyond diversification, the RBI mandate which enables P2P platforms to report loans intro credit bureaus is also a significant step in ensuring that borrowers are heavily disincentivised from defaulting on loan payments.
Therefore, a borrower who does not make timely repayments on a loan taken from a P2P platform faces the immediate penalty of getting his / her credit score downgraded which in turn seriously affects the borrower’s ability to access credit from other financial institutions in future.
How P2P platforms manage the flow of funds between the lender and borrower
P2P lending, being completely digital, might lead one to believe that the fund flow is happening directly between the borrower and the lender’s bank accounts. This is incorrect.
P2P platforms, as stipulated by RBI guidelines are beginning to use an Escrow Account. An Escrow account or a holding account becomes necessary to seamlessly manage the fund flow in a P2P environment. The Escrow does the work of holding the lenders’ funds, transferring funds to the borrower and collecting monthly repayments. The Escrow also ensures that the lenders’ funds is always at arms length and cannot be misappropriated by the P2P platform.
Monexo was India’s first P2P lending platform to implement the Escrow account framework for movement of funds between the borrower and lender.
Returns in P2P lending
Returns in a P2P lending portfolio are ultimately connected to the interest rates, tenor and repayment performance of underlying loans which the investor has chosen to invest in. Investors have the ability to build a portfolio of loans with a curated mix of low, medium and high risk loans.
Reinvestment of monthly cashflows also needs to be factored in to ensure that returns in P2P lending are significantly attractive. Since each loan is repaid every month in the form of an EMI, reinvestment of these monthly cashflows provide the benefit of compounding to the lender.
Overall, a P2P lending portfolio which is constructed and managed well with due adherence to loan selection and reinvestment can generate net interest income which is at least 2X higher than what is earned from a bank fixed deposit.
Budgeting for default risk before making a P2P lending investment
Just like mutual funds are subject to market risk, returns in P2P lending are also subject to underlying loan performance. Though P2P platforms provide sufficient tools for risk mitigation inclusive of borrower screening, portfolio diversification and collections support in case of delayed payments, it is critical for investors to budget for delinquency before making a P2P investment. As long as the lending portfolio of the investor is diversified with no significant concentration of capital in any specific loan – there is enough buffer for the investor to earn significantly rewarding interest income on a monthly basis.
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