Personal loan defaults: 7 key reasons behind the alarming trend

Small-ticket single loans, that are less than ₹10,000, are reporting increased defaults compared to large loans, and it is causing anxiety to money lenders.

It is impacting the borrowers of urban as well as rural small locations. It is imperative for borrowers as well as lenders to find out why these kinds of defaults are occurring so that risks may be avoided and lending can be made well judged and careful.

Here are 7 key reasons behind this alarming trend:

• NBFC dominance and new borrowers: NBFCs have a stronghold on small-ticket lending, catering to new borrowers in tier III cities with weak credit history and financial literacy. These borrowers, most of whom have never had formal credit in their lifetime, are highly susceptible to default.
• Rise in overdue money: There was a significant spurt in delinquencies among borrowers of personal loans who borrowed money specially between December 2023 and June 2024. This is a representation of the influence of macroeconomic conditions and the lending pattern of that time, with the borrowers being unable to repay due to challenging financial limitations.
• Financial inclusion challenges: The objective of financial inclusion through online lending has seen riskier borrowers, less creditworthy borrowers entering the formal credit market. Most of them are "thin-file" borrowers, those without any credit history and hence no established credit rating or credit score. Due to this, it is difficult for lenders to accurately analyze and understand their repayment capability.
• Reserve Bank of India concerns: Reserve Bank of India has been concerned about the rise in unsecured lending compelling banks to enhance monitoring mechanisms amid the rise in household debt and the risk of over leveraging by the borrowers. This is crucial to prevent the persistent increase in household debt and loans for consumption.
• Economic considerations: Declining macroeconomic conditions in the form of falling economic growth, accelerating inflation, and dormant wages are responsible for the rising financial pressure on borrowers. Most borrowers, particularly from lower economic segments, are taking loans to cover their routine expenses, thereby resulting in excessive borrowing and defaults.
• Inadequate borrower financial education: Inadequate borrower financial education is one of the major drivers that raise default levels. Most first-time borrowers of small ticket loans, who may not be knowledgeable about how to handle borrowed money. Such individuals find it difficult to keep their finances in order. Absence of good knowledge and proper guidance on budgeting for loan repayment leads to default, particularly when they go through financial challenges.
• Speed of loan disbursal, improper checks are causing challenges: The speedy disbursal of loans, especially online, has resulted in easier availability to money i.e., credit. It provides the borrower with an "instant gratification." Whereas it is important to note that some of the loans being distributed online are getting sanctioned without adequate checks on the repayment capacity of a borrower, which results in a greater likelihood of defaults.
• Inadequate strong collection mechanisms: Another issue of concern is that currently there are not strong collection mechanisms for small-ticket loans. This area of loan distribution is getting evolved and developed in India. Further, rural and rural area lenders face challenges such as lack of technology and infrastructure to recover the overdue loans in time efficiently. Due to this defaults pile up, and even so, they are hard to recover without adequate monitoring and collection systems.

These issues highlight the importance for improved risk assessment techniques, stronger monitoring methods, and individualized repayment schemes to counter the trend of increasing default rates in the small-ticket personal loan market.

Moreover, borrowers must be taught money management and lenders implement more conservative lending practices to ensure that borrowers and lenders are able to navigate the intricate landscape of small-ticket lending with minimal financial risk.

(Note: Raising a loan comes with its own risks. So, due caution is advised)