The act of lending money to each other has been practiced since early human civilization days. It is still a common cultural norm in countries like India to borrow money from peers. Be it borrowing money within business communities to meet capital requirements or getting help from extended families in the form of money in case of an emergency. This form of lending has been based mostly on trust with no collateral or guarantee to back these loans.
Just like any other aspect of our lives, technology is transforming the way lending used to work between people without any intermediary
. This modern version of lending backed by technology is called peer-to-peer lending or P2P lending. In this blog, we will explore the know-how of P2P lending and also take a look at some of its pros and cons to help you make better investment decisions.
How Does P2P Lending Work?
As the name suggests, peer-to-peer lending is a pretty straightforward process. All transactions are done via a specialized online platform. Following are the steps of the P2P lending process:
- A potential borrower in need of a loan fills out an online application on the P2P lending platform.
- The P2P lending platform then assesses the application and ascertains the risk and credit rating of the applicant. After that, the applicant is assigned the appropriate interest rate.
- When the application is finally approved, the applicant received all the available options from the investors and assigned interest rates.
- The applicant can explore the available options and choose the one that they deem fit.
- After receiving the loan, the applicant is responsible for paying periodic (usually monthly) interest payments and the principal amount at maturity.
Advantages of P2P Lending
P2P lending has some significant advantages for both borrowers and lenders. Some of them are listed below:
- Greater returns to the investors: Peer-to-peer lending offers higher returns to the investors compared to other forms of investments.
- More accessible source of funding: P2P lending is a more accessible source of funding than conventional loans from financial institutions for some borrowers. This is either because the borrower has a low credit score or because of the atypical purpose of the loan.
- Lower interest rates: Peer-to-peer loans usually come with lower interest rates because of the greater competition between lenders and lesser origination fees.
Disadvantages of P2P Lending
As convenient as some things sound, there’s always some downside to everything. There are some disadvantages that tag along with the advantages of P2P lending. These are listed below:
Credit risk: P2P loans are generally exposed to high credit risk. As the borrowers who apply for loans have low credit ratings that do not allow them to obtain a conventional loan from financial institutions, lenders should be aware of the default probability of their counterparty.
No insurance/government protection: The government does not provide any insurance or protection to P2P lenders in case of the borrower’s default.
Tax responsibilities: The interest that the lender earns from P2P lending is subject to HMRC tax requirements and the lender is obligated to meet those requirements.
FAQs
There are some important questions that you might want answers to before you decide to invest in or borrow through P2P lending. We’ve answered some of those for you here:
How much can you earn through P2P lending?
Like any other investment, your earnings mostly depend on the size of risk you’re willing to take. In P2P specifically, your earnings depend on two factors, one is the creditworthiness of your borrower, and the second is the tenure of your loan. The lower the credit rating of your borrower, the higher your returns, and the longer the period of lending, the higher your profit. There are two essential things that you need to consider while looking at the returns from P2P lending. First is the default rate and the second is the platform fees. Your earnings will be deeply impacted by these two factors, so evaluate them properly before investing.
What is the taxation policy on P2P earnings?
In P2P lending, lenders essentially earn from the interest that they get paid on their principal amount. So just like interest earned on any other instruments, interest earned on P2P lending is taxable. The amount earned through P2P lending is classified as ‘income from Other Sources’, which is added to the lender’s income and is taxed as per the tax bracket the lender falls in.
How big is the P2P lending market?
According to figures from Precedence Research, the P2P lending market was worth $83.79 billion in 2021. Furthermore, the market is expected to reach $705.81 billion by 2023. It sure predicts a promising future.
Conclusion
Investment in general is a tricky affair. The stakes keep getting higher with your increasing amount of investment but the returns are also worth all the risk when you finally earn them. There is no secret formula for exactly knowing your final outcome though, thorough research and weighing your pros and cons is a must when you’re investing in anything. So be cautious and take the risks that you can afford to.
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