Introduction

Over the last few years, peer-to-peer lending (or "P2P lending") has become a game-changing model in India, bringing a new dimension to traditional banking and making lending possible without banks. P2P lending matches borrowers and lenders using digital platforms, removing intermediaries and allowing them to achieve their financial objectives. In this article, we discuss how peer-to-peer lending operates, its advantages and limitations, and the framework of peer-to-peer lending in India as a perfect guide for investors interested in peer-to-peer lending investing.

What is Peer-to-Peer Lending?

Peer-to-peer lending (P2P lending), or crowd lending, simply allows individuals to borrow and lend money directly without banks being involved, through online platforms. Peer-to-peer lending platforms in India match lenders who want to lend money and borrowers seeking small amounts of funding. It is attractive to borrowers who may have difficulty getting loans from traditional institutions because of requirements they may not meet or because they have a limited credit history.

How Do P2P Lending Platforms Work?

The peer-to-peer lending process in India is simple but effective, utilising technology to facilitate the transaction. Here’s how it generally works:

The first step is registration. Both borrowers and lenders must register for a peer-to-peer lending platform and provide some personal information. To assess the borrower's credit risk, borrowers must give more information, including proof of income, employment details, and credit history.

The second step is the loan application and qualification. Interested borrowers apply for a loan and submit the detailed amount and purpose. The peer-to-peer lending platform uses various algorithms to assess the borrower's risk profile and completes credit checks.

The third step is to select lenders. Lenders can browse loan requests that are successfully matched with borrower descriptions that include specific characteristics, such as loan amount, interest, and borrower risk rating. Borrowers can choose to fund loans they are most comfortable with after considering their risk appetite and investment return objectives.

The last step is to fund the loan transaction and repayment. Loan funding always occurs when the borrower or lender agrees to finance the loan request posted by the borrower. The borrower will then repay the loan in set instalments, including interest. Once the borrower makes a repayment, the platform distributes it to lenders minus a service fee.

Platforms charge fees to cover their operational expenses in providing their service, such as credit checks (to assess the potential risk of default) and managing payouts and loans, so their platforms provide users an easy experience.

The Regulatory Environment

In India, peer-to-peer lending platforms under the supervision of the Reserve Bank of India (RBI) are known as Non-Banking Financial Companies (NBFC-P2P). The RBI has several Master Directions for NBFC-P2P Lending Platforms (2017) to oversee the responsibilities of operating under said regulations, thus protecting users on peer-to-peer platforms. Some of the essential directions include:

1. As with every entity, the platforms must register with the RBI and maintain a minimum net-owned fund of ₹2 crore.

2. A maximum leverage ratio of 2 means outstanding loans cannot exceed 2 times the platform's capital.

3. The platforms must also register with Mumbai's Department of Non-Banking Regulation.

These rules increase transparency and accountability and allow peer-to-peer lending to develop as a potentially safer investing or trading option in India. As you would in banks, remember that P2P investments are not insured deposits; due diligence is necessary.

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Advantages of P2P Lending

Peer-to-peer lending platforms in India offer distinct advantages for both borrowers and lenders:

For Borrowers: P2P lending opens credit availability to people who would otherwise not qualify for a bank loan (e.g., freelancers, people with a lower credit score, etc.). Interest rates for less creditworthy individuals can be competitive depending on their level of risk.

For Lenders: Peer-to-peer lending offers returns typically greater than traditional investing alternatives (e.g., savings, fixed deposits, etc.). Investors can also diversify their investment portfolio by funding more than one loan, which increases the chance that the overall rate of return reflects a good investment, even if one or more loans default.

The digital aspect of P2P lending platforms makes the process highly convenient for lenders and borrowers alike, with user-friendly interfaces and quick processing times.

Risks

While peer-to-peer lending in India looks promising, there are several risks that users should consider:

Default Risk: Borrowers do not pay, resulting in a loss for lenders. Although most peer-to-peer platforms take steps to provide borrowers with credit assessments, borrowers can still default.

Platform Risk: Platforms may shut down, preventing lenders from retrieving their funds. Selecting a platform regulated by the RBI will help reduce this risk.

Liquidity Risk: P2P investments are usually locked up for a fixed term until maturity, meaning borrowers have little liquidity over the life of the loan and potentially limited liquidity transferability due to P2P lending as an investment versus other, more traditional alternatives.

Lenders should diversify their investment across many borrowers and research platforms to mitigate these risks before investing their capital.

Tax on Income from P2P Lending

Interest earned from peer-to-peer lending investing is taxed in India as "Income from other Sources" under the Income Tax Act, 1961. The principal amount invested is not taxed, but lenders must include interest income when filing returns. If you have any questions about these requirements, consider seeking a tax professional.

Conclusion

Peer-to-peer lending in India is changing the financial world, creating a win-win scenario for borrowers requiring accessible credit and lenders seeking returns. While peer-to-peer lending platforms in India are a compelling alternative to traditional finance, it is important to understand the risks and rewards of investing in P2P lending. Using regulated platforms, diversifying investments, and keeping up-to-date and informed will ensure users can take full advantage of the opportunity presented through peer-to-peer lending investing to reach their financial goals. As the P2P market grows, it also represents the continued technology "democratising" finance trend.

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