P2P lending connects individual or institutional investors with borrowers (companies or salaried individuals) through an online platform. By providing a viable alternative financing option, P2P is relentlessly shaping the consumer lending landscape. Consequently, P2P lending markets are flourishing all over the world. It works like a peer-to-peer network, where one investor can finance multiple loans, or one loan gets financed from multiple investors. Thus, the network shows a multitude of cross-relationships between investors and borrowers. The key challenge for P2P lending investors is the effective allocation of their funds across different risk segments. Therefore, accurate assessment of the risk involved is imperative.
What is a credit risk score?
Credit risk scoring involves ranking individual P2P loans into a series of graduated categories of increasing risk from minimal risk to high risk (see table). It is assigned taking into account not only credit history but also a combination of numerous determinants of credit risk. The lender always seeks to minimize the risk of the investment. By understanding the fundamental determinants of a credit score, you may be able to earn better returns and lower your risk of default by investing in quality loans.
Key impact variables:
- Credit history: It explains the creditworthiness of a borrower and the probability that a borrower will meet his financial commitments. Credit history also plays a determining role in the risk category assigned to a borrower.
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Debt-to-income ratio: It is a useful parameter when formulating hypotheses about the repayment capacity and financial position of a borrower.
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City: Borrowers are from diverse geographies and mixed ethnicities, revealing distinctive behavior. You can diversify your portfolio by selecting loans from different cities.
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Years of work: Number of years of work is another factor that reveals the creditworthiness of a borrower.
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Monthly income: It reflects the current capital condition of the borrower.
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% financing: It is an important determinant of a measure of the financing success of a loan within a risk category. For example, if a primary borrower has already received 50% financing, then other lenders show herd behavior so that the borrower receives financing faster.
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Purpose of the loan: Lenders use the purpose of the loan (Small Business Financing, Wedding Loan, Appliance Loan, Home Renovation Loan) to decide on credit risk. It also affects the interest rate that is offered.
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Total assets: Total assets clarify the financial status of a borrower. The greater the total assets a borrower has, the greater the probability of successful repayments and the less probability of loan default by the borrower.
These variables are statistically analyzed to assign the net return and default rate within each risk segment. In P2P lending, you are investing in unsecured loans. Therefore, lenders face a potential risk of default. But this is a manageable risk. As? For smoother and more even returns, lenders are suggested to allocate their funds in small chunks across each risk category. It’s the simple principle of investing, by not putting all your eggs in one basket! In short, peer-to-peer (P2P) lending is a thriving online credit market, with a full range of lending products and investment opportunities. By providing a viable alternative financing option, you are slowly and steadily undermining the market share of traditional financial institutions.
