Small and medium enterprises (SMEs) are an indicator of the growing economy of a country. SMEs not only create thousands of hundreds, but also contribute significantly to a country’s Gross Domestic Product (GDP). SMEs are facing the single biggest issue around the world, a lack of financing or limited financing access. The reason for this is due to the lack of requirements to obtain financing from the banks or financial institutions (FIs). The traditional way of getting funds from banks requires many levels of filtering and background checking. Here it comes for Peer-to-Peer (P2P) lending to overcome this challenge.
What is Peer-to-Peer (P2P) Lending?
Peer-to-peer lending is a form of crowdfunding which individuals or businesses (requesters) seek for funds from a group of investors via a digital platform. The digital platform serves as the middle-man or intermediary between the requesters and investors. Digital platform will earn charges from transactions.
How Does Peer-to-Peer (P2P) Lending Work?
Here is an example of P2P.
Company A requests a fund of $50,000 to grow the business (Working Capital or Short Term Fund). Company A raises the request via a P2P lending platform online and provides investment opportunities to investors. Platform will do due diligence and background checking to assess the default risk of Company A. Once this step is done, the request will be uploaded to the platform. Any interested investors can choose to lend the money to Company A.
(Note: Investors are sending the fund to platform directly instead of credit directly into Company A)
Multiple investors can choose to deposit the funding until the target of $50,000 is achieved. The fund will be released by platform to Company A. Company A will then make monthly repayment to investors with interest charges. Charges for using the platform will be incurred as well.
Why Peer-to-Peer (P2P)?
For Businesses / SMEs
1. Easier access for funding
Since P2P lending is aiming to fill the gap between conventional banks and businesses, it aims to help out businesses that could not fulfill the requirements by banks. Businesses with smaller size and less than a few years of establishment would have difficulty getting loans / grants from banks.
2. More customized funding
Usually banks or financial institutions would require minimum loans like $100,000 or repayment tenure in years. Businesses that fulfill paper requirements might not need huge loans or long tenure to repay. That is why P2P fits into the needs. In P2P, businesses can request a small amount with a repayment period of less than 12 months.
3. No collateral
This would be ideal for small businesses when taking up loans / funds. Banks would require collateral (example, property, vehicles etc) in the case of any default (not being able to repay on time). Since you may not have collateral to offer, the P2P platform will assess you to determine a suitable interest rate to repay to investors.
For Individuals / Investors
1. Better returns
Returns come with risks. P2P would likely offer a higher rate than bank saving interest rate as it carries a certain percentage of default risk. The likelihood of banks to default and go bankrupt is near to zero, hence, it offers a low and steady rate.
2. Small amount to kickstart
You often hear about investment, and may have the perception that you would need thousands to go with. But with P2P, some platforms allow as low as $100 to start your investment. You can start small, and then reinvest your returns to new notes (new borrowers).
Is it good for your investment portfolio?
Despite that there is default risk or businesses may not be able to repay loans, the short answer for this is YES. Any investment would have the chance of losing money / capital. Bonds, stock investments, property investment, commodities etc, all of these investment classes would have risk, whether it is low or high. The only way of not losing any money is keeping it as cash or in banks (But you will still be losing to inflation).
With increasing interest in P2P, regulators have been placing more rules and regulations to platforms to safeguard investors’ interest. P2P platforms will need to conduct background checks to filter qualified SMEs and only post credit worthy notes to the platforms for investors to invest.
Bottom Line:
P2P lending is a high-risk investment option. (Of course, higher risk comes with higher return). With the coronavirus pandemic impact, more businesses may have difficulty to repay loans, hence, for investors, it would have a higher chance of losing their investments.
Nevertheless, I would highly recommend P2P as part of your investment portfolio to achieve diversification.
Always read and understand the business you invest in, never invest without knowing!