P2P lending is risky; investors must diversify their borrower profiles

Lenders get the benefit of monthly cash flows and control, but they must avoid platforms promising high returns

M Rajeshwar Rao, deputy governor at the Reserve Bank of India (RBI), recently flagged off the risks of lending on peer to peer (P2P) platforms at an NBFC (non-banking financial company) summit organised by the Confederation of Indian Industry.

“A large proportion of lenders on NBFC-P2P platforms are individuals and they are not well equipped to understand the risks involved in providing credit. Instead of educating the lenders about the inherent risks in the lending activity, NBFC-P2Ps have been observed to underplay the risks through various means, such as promising high or assured returns, structuring transactions, and providing anytime fund recall facilities,” he said.

Let us understand the key risks lenders face on these platforms and how they can mitigate them.    

P2P lending

P2P lending is an alternative asset class, compared to traditional ones such as mutual funds and fixed deposits. “It is one of the few fixed-income investments where you can earn a return of around 9-13 per cent on an average,” says Bhuvan Rustagi, co-founder and chief operating officer, Lendbox, a P2P platform. Returns can also go higher if lenders select high-risk borrowers.

Lenders get the benefit of monthly cash flows and control. “They can decide whom they lend to,” says Rustagi. They also get access to a diversified borrower base.

The main risk lenders face on P2P platforms is default, meaning borrowers may not repay loans. “You could lend to 100 borrowers, and any number of them, from all 100 or 50 or 20, could default, risking even your initial investment,” says Rustagi.

Experts caution that the higher returns borrowers get are on account of the higher risk they incur. “P2P-NBFCs act as platforms bringing lenders and borrowers together. According to the terms of their licence, they cannot accept deposits. The risks are significantly higher on these platforms than in an RBI-governed deposit taking institution,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

Borrower quality may present a risk. “Many borrowers turn to these platforms because they find it hard to access formal banking. In the event of a significant economic downturn, there’s a risk many may default on repayments,” says Dhawan.

Risks could also arise from the platform’s stability, including its finances, operations, and technology.

Lock-in, withdrawal norms

Different platforms offer products with lock-in periods of three, six, or 12 months, or more. However, withdrawing funds depends on several factors and isn’t guaranteed. You can only withdraw if your loans are performing well and there’s a buyer for your portfolio. Performing loans are listed on the secondary market, while non-performing ones are not. “To withdraw, another lender must be willing to buy your loan portfolio, providing you with liquidity. If your loans are underperforming, it’s unlikely you’ll be able to liquidate them,” says Rustagi.

The initial step is diversification: lenders should spread their investments across various lenders. According to the RBI, there’s already a limit: A lender can’t invest more than Rs 50,000 in a single loan. “It’s advisable for a lender to invest even less per loan and maximise diversification,” says Rustagi.

Lenders have varied risk tolerances. Some may prefer lending to high-risk borrowers with poor credit scores, while others might be more conservative. It’s crucial that lender select borrowers who align with their risk appetite.

It’s also essential to monitor transactions regularly and closely.

Checks you should run

Ensure that the platform is RBI-registered. “It must have the licence to do P2P lending,” says Arnav Pandya, founder, Moneyeduschool. 

The RBI requires platforms to maintain a net worth of Rs 2 crore. Ensure the platform adheres to this and is in strong financial health. Additionally, verify that the platform’s technology infrastructure meets the necessary standards, and is capable of managing high transaction volumes.

Lenders should review the platform’s portfolio performance. All platforms are required by the RBI to publish their performance data on their websites. Lenders need to examine the returns provided by the platform over the past years or since its inception. Look for consistent returns with minimal volatility. Assess the level of non-performing loans on the platform.

Speak to other lenders who have used the platform. Understand their experiences before deciding to invest.

Avoid platforms that guarantee returns. “The promise of very high rate of return should also act as a red flag,” says Pandya.

Finally, P2P lending should be a part of the high-risk bucket (including credit risk funds, high risk bonds, etc) within your fixed-income portfolio. “This high-risk bucket itself should not exceed 10-15 per cent of your overall fixed-income portfolio, depending on your risk profile,” says Dhawan.

How to choose the right borrowers

Ensure the lending platform provides comprehensive information on borrowers

Verify borrowers’ credit scores, average income, employment history, and the Fixed Obligation to Income Ratio (FOIR)

Look out for any negative PIN codes

If the platform rates borrowers, review them