What Happens If a Borrower Defaults on a P2P Loan?

P2P lending is a very high-risk investment for lenders as there is always a looming fear of the borrower defaulting. It is therefore common for investors to indulge in more due diligence and hesitation before initiating a P2P transaction.

The following sections cover what actions P2P platforms take to deal with P2P loan defaults.

What Is P2P Lending, and How Does It Function?

Peer-to-peer lending is an innovative form of crowdfunding carried out through online platforms. A P2P platform can be understood as an intermediary between the willing lenders of funds and borrowers that eliminates bank intervention of sorts. Majority of lending carried out on P2P platforms is unsecured i.e the lent amount is not backed by any physical or non-physical asset.

To register on a P2P website, a potential borrower must fill up an online application form similar to a traditional loan application form. After this, the P2P system will assess their profile based on the application data pertaining to identity, employment history, credit history etc. It is also a common practice for P2P platforms to leverage social media and data pertaining to usage of other relevant applications in order to better gauge the background of a to – be registered & verified borrower.

Next, this borrower’s credit profile will be published on the P2P platform. An investor registered on the same platform can browse through the profiles of borrowers and check their loan applications in the context of the investor’s unique risk appetite and decide whether or not to lend to the borrower(s) who’s profile was analysed. It is prudent to note that most platforms also permit registered borrowers to solicit funding from registered investors. The freedom of choice is provided to both the lenders and borrowers.

After a borrower and an investor reach a mutual agreement on the loan amount and interest rate, they sign a digital contract. This contract legally binds an investor to lend money and a borrower to repay the borrowed amount and the pre-discussed interest on the same within a pre-decided span of time.

Two distinct escrow accounts are created by virtue of the P2P loan contract.One for funds received from lenders and pending disbursal, and the other for collections from borrowers. Both the accounts are monitored and maintained by a Trustee. All transactions occur in these two accounts, and cash exchange is strictly prohibited.

After an investor transfers funds, the P2P platform will disburse it to the borrower post deduction of an upfront fee.

What is the typical profile of a P2P borrower?

A potential borrower can opt for P2P lending owing to the following reasons:

• Individuals applying for loans for the first time have no credit history, and their applications are more likely to be rejected by banks. P2P loans are a suitable alternative for such people.
• Potential borrowers with CIBIL scores too low to be acceptable by banks can apply for P2P loans.
• Banks and traditional loan systems ask for collateral before disbursing the loan amount. Any individual who does not have any such securities to offer as a pledge for the loan may choose P2P lending platforms for borrowing money.
• People who urgently need money and do not want to spend a lot of time on loan applications may opt for peer-to-peer loans.

Borrowings of such individuals are viewed as high-risk investments. Therefore, P2P lenders usually demand high-interest rates from such borrowers.

What Measures Do Platforms Take to Avoid P2P Loan Defaults?

While investing on P2P platforms, an investor must keep in mind that there is always a chance of the borrower defaulting. Defaulting implies failure to pay single or multiple interest instalments and/or principal repayment.

Even though there is a filtration process while accepting loan applications, P2P loan defaults are an inherent risk that lenders must bear. In the instance of a default, P2P platforms take all necessary measures to recover the default amount. However, they do not guarantee a successful recovery of funds.

Measures taken to avoid defaults

Generally, P2P platforms incorporate the following measures to curtail events of default:

• Set up an auto-repayment option to debit the EMI amount from the borrower’s account before its due date. This would prevent missed payments in the future.
• Follow-up emails and text messages to remind borrowers of upcoming repayment dates.
• Repayment dates are more likely to fall within the first 10 days of a month. In case a borrower forgets or cannot repay within the 10^th day, they are likely to receive a 5-day grace period.
• If the borrower does not make timely payments, the P2P platforms will make follow-up calls reminding him/her about the missed payment.

Measures taken on defaulters

When a borrower fails to repay his/her loan amount and interest even after the provided grace period, he or she will be considered an intentional defaulter. Under such circumstances, the platform will take the following measures on on the intentional defaulter:

• In case a borrower does not repay his/her P2P loan after 30 days, the platform issues a warning against them.
• If there is no repayment after around 60 days of the due date, a legal notice will be sent to the defaulter.
• If a borrower continues to miss payments, P2P lending platforms use their security check to recover the amount. The defaulting borrower must comply else platforms take legal actions against them.
• Next, they can file a case under Section 138 of the Negotiable Instruments Act, 1881, against a P2P loan defaulter.
• In-house staffs of a P2P platform first communicate with defaulters and follow them up for pending payments. If this does not work, they may connect with registered collection agencies to follow up with the borrower.
• P2P platforms update lenders on their P2P accounts about every step undertaken for recovery.

How Can a Lender Avert the Risks of P2P Loan Defaults?

When investing in a P2P platform, a lender must know there are high chances of defaults. Therefore, they must keep certain points in mind while lending. Here are a few points that are helpful for lenders to mitigate risks of P2P loan defaults.

• Lenders must perform a detailed study of a selected borrower’s profile to assess the degree of underlying default risk. Unfortunately, most borrowers who apply for P2P loans have poor credit scores or no credit history. Hence significant judgement in addition to common sense needs to be deployed at the time of assessment.
• A lender must consider several factors, such as a borrower’s fixed obligations, average quarterly balance, income ratio, and data from his/her credit report. These provide necessary information about a borrower’s risk of default based on his/her income and past debts.
• P2P lenders cannot invest more than ₹50,000 in borrowers as per the Reserve Bank of India regulations.
• People should not consider P2P lending activities as high-return investments though they can generate high-interest income from borrowers with poor credit ratings. Investing with such an approach could massively backfire in the event of a default, especially when investing large amounts.

RBI Regulations on P2P Platforms

With the growing popularity of P2P lending in India, RBI has formulated certain regulations to monitor financial activities in this sector. You can find these regulations in RBI Master Guidelines on Non-Banking Financial Company- Peer to Peer Lending Platform (Reserve Bank) Directions, 2017.  

Here are some important points that lenders and borrowers need to know about these guidelines:

• Any company that offers P2P lending must get an NBFC-P2P licence from RBI.
• Any person, business, body of individuals, firms or society can participate in P2P lending.
• Every P2P investor must acquire a lending certificate for themselves from the RBI.
• A P2P platform must have a minimum of Rs. 2 crore in net-owned funds to function and fulfil other RBI mandates.
• The leverage ratio should not be above two.
• Lenders should not invest more than ₹10 lakh across P2P platforms. This ensures that high net-worth individuals do not consider themselves new-age lenders and thereby replace the banking system.
• A single lender cannot lend funds above ₹50,000 to a single borrower. 
• Lenders must know the borrower’s details and credit scores before investing.
• An individual cannot borrow funds of more than Rs. 10 lakh across all P2P platforms.
• NBFC-P2P staff cannot harass or bully borrowers for repayment of P2P loans.
• P2P platforms cannot provide a lender’s personal and contact details to borrowers.
• All NBFC-P2Ps must update the RBI quarterly on certain aspects of business operations.
• NBFC-P2Ps must get RBI’s approval on a material change of ownership or management changes.

Final words

P2P lending is a very high-risk investment strategy that offers high, fixed returns but allied with above average risk of default. Therefore, an investor must study the rate of defaults associated with P2P platforms before investing. A P2P platform with a low default rate reflects that it has taken proper measures to manage P2P loan defaults and recover money.

Frequently Asked Questions