The other day someone posted a link to a Peer to Peer (P2P) lending company on a whatsapp group, and asked the members for their opinion on investing in such a scheme.
For those of you who are familiar with the concept of P2P lending, feel free to skip this paragraph. For the uninitiated, let’s first start with banks. Their main function is taking deposits from people, either in the form of cash in your account or fixed deposits. They then loan that money out to people or companies who are looking for funds. They charge the borrowers interest, keep some money for themselves, and pass on the remaining to the depositors. Borrowers get to pay lesser interest if they are putting collateral on the loan (house, vehicle, plant machinery, etc.), or have a proven history of paying back loans on time, and so on. By the same token, depositors get more interest if they are willing to deposit larger sums of money, or deposit it for longer periods of time. And the bank still make its margins.
The banks now have a dangerous task: how do you select those debtors who are more likely to pay their money back, and reward them with a low interest rate? How much interest do you charge a more “risky” debtor, who has a higher probability of defaulting on her loan? And finally, how do you balance out your loan portfolio and ensure that your depositors, who have trusted the bank with their capital, are not exposed to the risk of losing their money?
Thankfully banks have developed complex algorithms to help them decide this. The idea of credit scores, (however faulty) are an important part of this. (There are also slippages like the recent spate of high profile borrowers taking massive chunks of money and running abroad, but this is because the due diligence of the banks being cut short.) At its heart, the reason the system works is because of the economies of scale: banks simply have so many debtors and depositors that they can easily reduce the risk in the loans they are making by simply loaning money to a wide variety of borrowers, who are willing to pay a wide variety of interest rates.
At its heart, the reason the system works is because of the economies of scale: banks simply have so many debtors and depositors that they can easily reduce the risk in the loans they are making by simply loaning money to a wide variety of borrowers, who are willing to pay a wide variety of interest rates.
P2P lenders cut out the bank from this picture. If you are a borrower, your creditworthiness is assessed by the website, and an interest rate is decided for you. If you are an investor, they put the onus of selecting the people whom you want to loan your money to.
The particular website I was browsing requires you to invest atleast Rs. 1 lakh. You can then loan as little as Rs. 1000 to an individual borrower, and make a portfolio of upto 100 loans in this fashion. All of these borrowers would pay you back with interest over the tenure of the loan, which could be from 12 to 36 months.
The website promises returns between 15% and 36% on your money. Sounds fantastic, doesn’t it? Well, you should remember that nothing comes for free in the financial markets. There’s no free lunch! In this case, how do you evaluate the default risk? Lets say that one of your hundred borrowers loses her job. That’s a 1% NPA, (Non Performing Asset) to use current parlance. Do you have the capability to withstand such a loss? If you say yes, read on.
Lets say that there is a systemic downturn in the economy, and the IT industry starts downsizing. If you’ve loaned 50% of your portfolio to people working in IT jobs, you’re staring at a 50% NPA problem. Do you have the capability to withstand such a loss?
If your answer is “yes, because I am attracted by the outsize returns that this scheme is offering”, you should re-consider if this is investing or speculation for you. Investing is always about protection of capital, and growth of capital over the long term with the hopes of beating inflation. Speculation, or the more dashing Hindi word Satta, is about out-size short term gains with the understanding that the full capital is at risk. Exactly like a bet at the races – you could buy a ticket for Rs. 100 and hope to win Rs. 10000, with the full understanding that you could lose all of your Rs. 100.
In conclusion, should you invest in a P2P lending scheme, or something similar which offers unbelievable returns? First, don’t call it an investment, call it speculation. Second, if you’ve made the choice to speculate, feel free! Remember to restrict the amount you speculate to an sum that you can afford to lose, because it isn’t much different from a lottery. Good luck!