A reader wants to know if he can use P2P lending as a fixed-income instrument in his portfolio. Many portals that facilitate P2P lending flash double-digit returns with slogans like “better return that FDs”. But are they worth your time and money?
P2P lending, or peer-to-peer lending, is a method of borrowing and lending money directly between individuals or businesses without the involvement of traditional financial institutions such as banks or credit unions.
This type of lending occurs through online platforms that connect borrowers with potential lenders, who can be individual investors or institutions. P2P lending platforms typically offer lower interest rates for borrowers and higher returns for investors than traditional lending methods, as they eliminate the overhead costs associated with banks.
The two major risks are:
1. Default risk: Borrowers may default on their loans, leading to losses for the investors who lent them money. P2P lending platforms try to minimize this risk through credit checks and risk assessments, but defaults can still occur. When the going is good, everything seems hunky dory, but when businesses start to fail, it can result in a domino effect, and things can turn quickly sour. The trouble with credit risk is its invisibility. No one recognises its existence until it strikes.
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2. Platform risk: The P2P lending platform itself may fail or go bankrupt, leading to losses for both borrowers and investors. Guidelines and registration with RBI are hardly a guarantee against this risk.
3. Liquidity risk: How easily can you get your money back if you need it mid-tenure? To our knowledge, liquidity is quite poor. Some platforms allow a loan transfer to other lenders, but this may not always be possible.
Does it make sense to use P2P lending as a form of fixed income?
Certainly not! Chasing after high returns in fixed income is one of the worst investor mistakes. No one in their right mind would put a significant chunk of their net worth on such platforms. So at best there will be a “small exposure” of 10-20%. That small exposure earning a higher than FD return (until it lasts) will not make a big difference to our net worth. Therefore our time and money are best spent and invested elsewhere.