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P2P lending matches individual or institutional investors with borrowers (businesses or salaried individuals) through an online platform. By facilitating viable alternative financing options, P2P continues to shape the consumer lending landscape. As a result, P2P lending marketplaces are flourishing around the world. It operates as a peer-to-peer network, where one investor can finance multiple loans, or one loan receiving funds from multiple investors. Thus, the network reflects multiple crossed relationships between investors and borrowers. The major challenge for investors in P2P lending is the effective allocation of their funds across different risk areas. Therefore, an accurate assessment of the risk involved is imperative.
What is Credit Risk Rating?
Credit risk ratings include the classification of personal P2P loans into a series of graduated categories of increasing risk from low risk to high risk (see table). It is assigned taking into account not only the credit record but also a combination of several determinants of credit risk. The lender is always trying to reduce the risk on the investment. With knowing the fundamental determinants of credit risk rating, it is possible for them to earn better returns and reduce default risk by investing in quality loans.
Main Effect Variables:
- credit record: It describes the creditworthiness of a borrower and how likely a borrower is to meet his or her financial commitments. Credit record also plays a determining role on the risk bucket assigned to a borrower.
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Debt-to-Income Ratio: It is a helpful parameter while envisaging the repayment capacity and financial position of a borrower.
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City: Borrowers belong to diverse geographies and mixed ethnicities, exhibiting distinctive behaviours. You can diversify your portfolio by choosing loans from different cities.
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Working Years: Number of years in service is another factor that reveals the creditworthiness of a borrower.
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monthly income: It reflects the current capital position of the borrower.
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% Age Fund: It is an important determinant of the measure of the success of a loan on loan within a risk bucket. For example, if a prime borrower has already secured 50% of the funding, other lenders show a herd behavior to obtain faster funding for one borrower.
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Purpose of Loan: Purpose of the loan (Small Business Grant, Wedding Loan, Home Appliance Loan, Home Renovation Loan ) is used by lenders to decide on credit risk. It also affects the interest rate offered.
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Total assets: Net worth clarifies the financial position of a borrower. The higher the net worth of a borrower, the better the chances of successful repayment and the lower the chances of the borrower defaulting on the loan.
These variables are statistically analyzed to assign the net return and default rate within each risk bucket. In P2P Lending you are investing in non-collateralized loans. Therefore, lenders face the potential risk of default. But it is a manageable risk. How? For smooth and consistent returns, lenders are suggested to spread their funds in smaller tranches across each risk bucket. It’s a simple investing principle by not putting all your eggs in one basket! In short, Peer to Peer (P2P) lending is a growing online credit marketplace with a full range of loan products and investment opportunities. By facilitating viable alternative financing options, it is slowly and steadily reducing the market share of traditional financial institutions.
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