We live in a modern world of the internet where technology has changed almost everything around us. Be it shopping, booking holidays, e-books, or air tickets, everything can now be done online from the comforts of your home and in most cases in a cost-effective manner. Similarly, we no longer need to rely on brick-and-mortar financial companies for loans.
There are now online Peer to Peer (P2P) lending platforms where one can lend his/her ideal money to borrowers in need. As the Peer to Peer (P2P) platforms do not have any branches, borrowers get to borrow money at a lower cost whereas lenders can take advantage of the handsome returns of up to 24% on the money they lend to a borrower.
But how do these platforms protect the lenders against bad loans and other risks? Let us have a look.
A major risk of lending money through Peer to Peer (P2P) platforms is that the borrower might not return some part or the entire borrowed amount. To mitigate this risk, P2P platforms follow a number of important steps diligently to keep the risk at a minimum.
For instance, apart from the traditional data like the salary slips, income tax returns and bank statements of the borrowers, the P2P platforms also carefully evaluate the online transaction data, digital data, social data, mobile data and hundreds of other data points to understand the stability, intention and ability of the borrower to repay the loan. While the credit score is also considered important, P2P platforms abundantly rely on advanced algorithms for identity verification process of the lenders to eliminate applications which appear fraudulent in nature.
If a diversified and large pool of borrowers is not available, there will always be a concentration risk as the investors wouldn’t be able to diversify the investment across different risk grades and yield types. Exposure to only a particular type of borrowers, like the ones from the same city, carrying similar risks, gender, loan purpose, loan amount, tenure, community/caste, etc. can be very risky.
P2P platforms thus lay a major emphasis on providing a diversity of borrowers to the lenders. Diversification is one of the most important steps for any kind of investment and P2P platforms offer this benefit to prevent the concentration risk. Lenders get to choose from many different types of borrowers who are differentiated on the basis of risk grades, loan purpose, tenure, caste/community, gender, location and other factors.
One of the most important benefits of lending money through P2P platforms is the high returns which lenders earn from the interest that the borrowers pay. However, if a borrower decides to prepay the loan before the scheduled repayment tenure, the lender has a major risk of losing the income from the interest which the borrower was supposed to pay.
While the P2P platforms themselves do not charge any prepayment penalty, there are some platforms which charge a penalty of 5% along with the interest amount that is due till the date of payment. This penalty and interest are directly paid to the lender to make up for his/her losses.
Risk of credit policy
If the P2P platform uses credit processes and policies which are not at par with the needs of the lender, lending might not help an investor achieve his/her investment objective.
As a result, P2P platforms focus on having a strong and experienced risk team. The risk department is made up of people that have a strong track record with respect to risk management and practices. Even the data science team of the platform has extensive experience in producing analytical data for improving the decision-making process for the lenders.
The macro risks are risks which cannot be completely eliminated by the Peer to Peer (P2P) platform. For instance, the borrower might not be able to repay the loan due to a natural disaster in his/her city, economic recession, terrorist attack, or political turmoil.
In such cases, the lender always has the right to collect the due amount in future when the state is out of the natural disaster’s impact or is done with the recession. The P2P platforms offer all the legal help and expertise to initiate proceedings against the borrower in case of non-payment. Even the cost of all the legal action is reimbursable by the borrower.
P2P loan platforms are one of the most disruptive and revolutionary innovations of the financial sector in recent times. While every type of investment comes with some amount of risk, reliable P2P platforms take adequate steps to keep the risks to a minimum and allow investors to earn maximum returns on their investment.