Micro Loans vs. P2P Lending: What’s the Difference?

According to a recommendation paper submitted by the India SME Forum to the RBI, the estimated $530 billion financing gap for MSMEs has been growing recently, presenting serious difficulties. As a result, a sizable portion of the MSME sector remains underserved, impeding their ability to grow and compete in an increasingly globalised market.

In order to close credit gaps, micro, small, and medium-sized businesses (MSMEs) have urged the Reserve Bank of India (RBI) to create a regulatory framework for peer lending for MSMEs to address capital issues hindering their growth. Thus, peer-to-peer lending and micro loans can make a world of difference to those who lack access to formal financial institutions. Let's understand how.

What are Micro Loans?

Micro loans are small loans typically offered by microfinance institutions (MFIs) or small finance banks to individuals or groups who have limited access to traditional banking services. These loans are aimed at supporting entrepreneurial ventures, income generation, and financial inclusion in rural and semi-urban areas.

Example:

Ramesh who runs a small grocery store in a village, does not have access to traditional banking services due to lack of credit history. Ramesh can approach a microfinance institution for a loan to fund his expansion plans.

Micro loans also have shorter repayment periods compared to traditional bank loans. This allows borrowers to repay the loan quickly and potentially take out subsequent loans as they grow their businesses.

Understanding P2P Lending

Peer-to-peer lending, on the other hand, is a digital lending platform where individuals can borrow and lend money directly from each other without the involvement of traditional financial institutions. P2P lending platforms connect borrowers and lenders through an online marketplace.

Unlike micro loans, P2P lending is not limited to a specific target audience. Anyone with a good credit score and a steady income can participate as a borrower or lender on these platforms. An advantage of P2P lending is that it offers competitive interest rates compared to traditional banks. Since borrowers are connected directly with individual lenders, there are no middlemen involved, reducing the overall cost of borrowing.

Example:

Let's say Priya wants to renovate her house. She can choose to apply for a loan through a P2P lending platform where individual lenders offer loans at lower interest rates based on her creditworthiness.

Micro Loans vs. P2P Lending

To understand the key differences between micro loans and P2P lending, let's compare these alternative lending options across different parameters:

1. Eligibility Criteria

• Micro Loans: Accessible to individuals or groups with limited access to traditional banking services.
• P2P Lending: Any individual with a good credit score and steady income can participate.

2. Loan Amount

• Micro Loans: Typically, smaller loan amounts suited for entrepreneurial ventures or income generation.
• P2P Lending: Allows borrowers to request higher loan amounts depending on their creditworthiness.

3. Interest Rates

• Micro Loans: Interest rates vary depending on the microfinance institution and borrower's profile.
• P2P Lending: Competitive interest rates as borrowers negotiate directly with individual lenders.

4. Repayment Period

• Micro Loans: Shorter repayment periods to support quick loan turnover.
• P2P Lending: Flexible repayment periods depending on the borrower's agreement with lenders.

5. Borrower-Lender Relationship

• Micro Loans: Borrowers have a direct relationship with the microfinance institution.
• P2P Lending: Borrowers interact directly with individual lenders through an online platform.

6. Collateral Requirement

• Micro Loans: Often do not require collateral.
• P2P Lending: Collateral may or may not be required, depending on the individual lender's preference.

7. Level of Regulation

• Micro Loans: Regulated by financial institutions such as microfinance institutions or small finance banks.
• P2P Lending: Governed by guidelines issued by the Reserve Bank of India (RBI) for peer-to-peer lending platforms.

Calculation:

Let's understand the financial implications of micro loans vs. P2P lending. Suppose you borrow ₹1 lakh for a business expansion project. The interest rate offered by a microfinance institution is 18% per annum and that on a P2P lending platform is 12% per annum.

Calculation for Micro Loan:

Interest payable = Principal amount x Annual interest rate

Interest payable = ₹1,00,000 x 0.18 = ₹18,000

Calculation for P2P Loan:

Interest payable = Principal amount x Annual interest rate

Interest payable = ₹1,00,000 x 0.12 = ₹12,000

In this scenario, opting for a P2P loan can result in savings of ₹6,000 in interest.

Example:

Imagine you are a young professional planning to buy a car. You need a loan of ₹5 lakhs to finance your purchase. While considering different options, you come across micro loans and P2P lending as alternative financing methods.

You analyse your requirements and decide that the application process and quick approval of micro loans align better with your needs. You approach Ujjivan SFB, provide the necessary documentation, and receive the loan amount within a short period. This enables you to purchase your dream car without any delays.