P2P lending matches individual or institutional investors with borrowers (businesses or salaried individuals), by means of an online platform. By facilitating a viable alternative financing option, P2P is unceasingly shaping the consumer lending landscape. Consequently, P2P lending marketplaces are flourishing across the globe. It operates as a peer to peer network, where an investor can fund multiple loans, or one loan is getting funding from multiple investors. Thus, the network shows a multitude of the crossed relationship between investors and borrowers. The key challenge for investors in P2P lending is the effectual allocation of their funds across different risk buckets. Hence, the accurate assessment of the risk involved is imperative.
What is a Credit Risk Rating?
Credit risk rating involves the classification of individual P2P loans into a series of graduated categories of increasing risk from minimal risk to high risk (refer to table). It is assigned by taking into account not only the credit record but, also a combination of numerous determinants of credit risk. The lender is always seeking to minimize risk on investment. With knowing the fundamental determinants of credit risk rating, it possible for them to earn better returns and decrease the default risk through investing in the quality loans.
Key impact variables:
- Credit record: It explains a borrower’s creditworthiness and how likely, a borrower meets its financial commitments. Credit record also plays a determining role on risk bucket assigned to a borrower.
- Debt-to-income ratio: It is a helpful parameter while hypothesizing the repayment capability and financial position of a borrower.
- City: Borrowers belong to diverse geographies and mixed ethnicities, revealing distinctive behavior. You can diversify your portfolio by selecting loans from different cities.
- Working years: No. of Working years is another factor that reveals the creditworthiness of a borrower.
- Monthly Income: It reflects the current capital condition of the borrower.
- %age funding: It is an important determinant of a measure of funding success on loan within a risk bucket. For instance, if a prime borrower already received 50% of funding, then other lenders show a herding behavior for a borrower to receive faster funding.
- Loan Purpose: The purpose of the loan (Small Business Funding, Wedding Loan, Home Appliances Loan, Home Renovation Loan ) is utilized by the lenders to decide on the credit risk. It also impacts the interest rate that is offered.
- Total asset: The total asset elucidates the financial status of a borrower. The higher the total assets a borrower has, the better the probability of successful repayments and a lower chance of loan default by the borrower.
These variables are statistically analyzed to assign the net return and default rate within each risk bucket. In P2P lending you are investing in uncollateralized loans. Therefore, lenders face a potential risk of default. But this is a manageable risk. How? For smoother and consistent returns, lenders are suggested to spread their funds in small parts into each risk bucket. It is the simple principle of investing, by not putting all eggs in the same basket! To sum up, Peer to Peer (P2P) lending, is a burgeoning online credit marketplace, with a full range of loan products and investment opportunities. By facilitating a viable alternative financing option, it is slowly and steadily nibbling the market share of traditional financial institutions.