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What Is Peer-To-Peer Lending And How Does It Work?

India has always had a culture of people lending money to each other. Be it within business communities where people borrow money to meet working capital requirements or extended families helping each other out in an emergency. Most of this lending is based on trust with no guarantee or collateral to back these loans. This traditional way of lending, just like every other aspect of our lives, is being transformed by technology. The new modern version of lending to each other is called peer-to-peer lending or (P2P) lending.

What Is Peer-To-Peer (P2P) Lending?

People typically look for a loan from banks or other financial institutions like Non-Banking Financial Companies (NBFCs) whenever they need money. But on many occasions, these institutions reject the loan application based on income, inadequate paperwork, low credit score, etc.

In such a situation, sometimes friends and relatives in their social circle come to the rescue, and people borrow money from them. But those who lend the money only do that when they know the borrower through mutual connections and are confident that they will get back the money. The limitation of this type of lending model is that people can lend and borrow from only a few people in their circle. Thus, many people do not get a source of financing in critical junctures of their life.

Peer-to-peer (P2P) lending can come in handy during such challenging times. P2P lending works as the much-needed mechanism through which people who want to give loans connect with those who require money. The borrowers pay interest, and the investors/lenders earn interest.

Since the transaction directly takes place between the two parties through a website or application, it eliminates the need for financial institutions like banks to act as the middleman.

Thus, as a source of financing, P2P lending has the potential to extend financial inclusion globally. People with low credit scores or people that lie in the low-income category find P2P lending highly accessible. With the help of P2P lending, borrowers can get a loan to finance their education, debt refinancing, expand their business, etc. P2P lending is convenient, as you can do it through websites or applications, also known as P2P Lending Platforms.

How Does P2P Lending Work?

P2P lending is done through a website that connects borrowers and lenders directly. Those who want to lend money, open an account with a P2P platform as a lender. And those who require a loan register themselves as a borrower.

These platforms then evaluate borrowers on various aspects. They don’t limit their evaluation to just credit scores. They perform their checks, including the borrower’s employment, income, credit history, etc. Not just that, using technology extensively, these platforms also capture borrowers’ habits through social media activities, app usage, etc.

Based on this assessment, the creditworthiness of borrowers is decided, and they are assigned to different risk buckets. It serves as the basis for how much interest rate a borrower needs to pay. The better the creditworthiness of a borrower, the lower the interest rate for him. And the poorer the creditworthiness, the higher the interest rate a borrower has to pay.

Lenders can check this assessment done by the platform for various borrowers and pick whom they want to lend their money as per the risk they want to take and the return they want to earn. Similarly, borrowers can also see the profile of lenders and reach out to them.

The P2P platforms do not keep a margin from the monthly installments or transactions between the lender and the borrower. Instead, they charge a fee from both for the services that they provide. To make sure that the platforms don’t do anything fishy or fraudulent, like holding on to money invested by the lenders or money paid back by borrowers, RBI regulates these platforms.

P2P Lending: Understanding The Risks

The price of market-linked products like stocks, bonds, gold, or mutual funds fluctuates daily. However, there is no market-related risk in P2P lending. So the value of your investments in P2P lending will not fluctuate daily.

The risk involved with peer-to-peer lending is the risk of default by the borrower, i.e., the borrower doesn’t pay the interest and the principal amount. If a borrower defaults, a P2P platform can assist the lenders in recovery and file legal notice against the defaulter. But that is all the platform can do. It does not guarantee the recovery of lenders’ money.

Since the default risk is the primary risk you are taking as a lender, the assessment of potential risk a borrower brings to the table becomes the key. Unfortunately, as investors, you are entirely at the mercy of the P2P lending platform’s evaluation. So if the platform’s risk-scoring model is not great and it cannot correctly gauge the risk levels of the borrower, you end up taking far higher risk than you might want to.

One argument given to counter the credit risk is that investors can diversify their investments across various high-creditworthy borrowers. While this strategy can help you minimize the risk to some extent, it doesn’t make the investments completely risk-free.

P2P Lending Returns: How Much Can You Earn?

Like any investment, the return in P2P lending depends on the risk you are willing to take. You can measure the risk in P2P lending on two parameters: one, the borrower’s creditworthiness. And two, the tenure for which you lend.

The longer the lending period, the higher the returns. And, the poor the credit track record of a borrower, the higher the returns.

Taxation On Returns From P2P Lending

In P2P lending, investors essentially earn interest from the amount they lend. Thus, just like interest earned from other instruments like FDs, interest income from P2P lending is taxable.

The interest amount earned from P2P lending is classified as ‘Income from Other Sources.’ It is added to the lender’s income and taxed as per the tax bracket lender falls in. So if someone is in the 30% tax bracket, he will pay 30% tax on the interest earned.

For instance, say, you invested Rs. 1 lakh in P2P lending, and the interest you earned from the principal amount is 15% or Rs. 15,000. If you are in the 30% slab, you will pay Rs. 4,500 (30% of Rs. 15,000) in taxes.

This tax treatment has a significant impact on your final returns. In the above example, your effective post-tax return comes down to 10.5%.

Should You Invest In P2P Lending?

At a time when banks are giving around 5% interest on 1-year FDs, the prospect of earning a 12-14% interest per annum through P2P lending indeed looks attractive. However, investing in P2P lending is fraught with risks as well. In fact, investing in P2P lending is even riskier than investing in Equity Funds.

Moreover, these are pretty early days for the investment product. RBI started regulating P2P lending in 2017. So It is yet to go through its evolutionary cycles and can have multiple unpleasant events.

This Content has originally written by ET Money Team and published on October 3, 2022.

No Copyright/IPR breach is intended.

Click Here to read Original.

Photo by Karolina Grabowska

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