Synopsis: This blog delineates the risks inherent in accessing informal credit and expounds on the rationale for opting for formal lending institutions.

There is no denying that accessing timely credit is essential to achieving individual empowerment and driving economic growth. From establishing a new business, scaling current operations, and buying new equipment to meeting daily expenses, loans are a critical way to bring money to the table when bootstrapping is not an option. A 2023 report, “MSME Lending”, estimates India’s total credit demand to be around $1,544 billion, with almost 47% representing those with strong preferences for informal credit or those with currently unviable business plans.

While Indian individuals and businesses enjoy the choice to apply for loans through informal credit sources, such as family, friends, neighbors, and local moneylenders—given their easy accessibility and flexibility—they harbor substantial risks. Compared to their formal counterparts like banks and NBFCs, informal creditors fare poorly in terms of offering transparent loan terms and ensuring consumer protection.

Below, we outline the perils associated with accessing loans from informal sources of credit and the need to switch to formal lenders, given their more structured and transparent approach to lending.

Risks Inherent in Informal Credit Channels

The incessant popularity of informal credit can be attributed to its inherent information advantages, as business owners leverage personal connections and social capital to seek loans. Indeed, some venture that India’s cash-based informal credit market is worth a colossal $500 billion, with friends and family (F&F) loans accounting for a 40% share.

Moreover, informal loans eliminate the need to exhibit a strong credit score or high financial literacy—a common requirement among all formal lenders. Yet, these benefits entail their own risks and costs, which are listed as follows:

1. Limited Transparency and Documentation

The lack of any regulatory oversight veils the informal credit segment in opacity, which can eventually cause disputes and legal complications. The absence of legally binding agreements makes both lenders and borrowers susceptible to the unanticipated consequences of a counterparty defaulting on its payments. Additionally, informal loans sought from unregulated moneylenders may involve unclear and unfair credit terms and other hidden costs, which can worsen the borrower’s position, forcing them into a vicious debt trap.

2. Lack of Consumer Protection

Unlike formal lending institutions, which adhere to established laws and regulations, informal lenders often operate outside of such frameworks. For instance, the RBI has released guidelines on regulated entities, ensuring none of their empaneled loan recovery agents resort to physical or verbal harassment to recover loans. But borrowers taking loans from informal lenders are afforded no such protection and instead are exposed to exploitative practices, severe intimidation, loss of privacy, and exorbitant interest rates.

3. Impact on Credit Score and Financial Health

Borrowers lose out on the benefits of building a credit history when they choose to engage with informal credit sources. As informal loans are typically undocumented, their repayment history does not get factored into credit scores, which are critical for determining any loan applicant’s creditworthiness. This further limits their credit access to unregulated borrowing for future endeavors, hindering their ability to secure favorable terms or larger loans from formal institutions.

4. Potential Loss of Social Capital

While informal lending does entail some benefits, with moneylenders foregoing the need for collateral in some cases, such loans are often provided based on one’s social positioning and capital, which is encashed to ensure repayment. However, a single payment default can permanently strain such relationships and damage the borrower’s reputation. This is unlike formal loans requiring some form of collateral, which can be liquidated to ensure partial recovery and de-hyphenate all personal and professional relationships.

Formal Lending Institutions as Alternatives

In light of the potential pitfalls associated with unregulated borrowing, opting for formal lenders presents a better alternative to availing loans and ensuring long-term financial well-being. Regulated lenders, including commercial banks, cooperative societies, payment banks, government institutions, microfinance institutions, and digital lending platforms, offer a range of advantages that bolster financial security and long-term stability.

1. Structured and Transparent Processes

In contrast to their informal brethren, formal lending institutions follow standardized and structured lending processes (as outlined in regulatory guidelines) that follow clear documentation and communication practices. They provide legally binding agreements to their borrowers that explicitly outline interest rates, processing fees, repayment terms, and customer rights, minimizing the likelihood of any future conflicts and, hence, fostering trust between parties.

2. Personalized Credit Offerings

Keeping up with the ever-evolving technological landscape, banks and other financial institutions have been offering innovative credit products and services such as co-branded credit cards and buy now, pay later (BNPL) loans to new-to-credit (N2C) customers. Besides, leveraging artificial intelligence (AI) and machine learning (ML)-driven models has enabled new-age lenders to offer customized loans to consumers based on their transaction history, revenue trends, etc. The development of the India Stack and Account Aggregator system has further cemented the process of credit formalization.

3. Better Financial Management and Literacy

One of the added advantages of applying for loans from formal lenders is that such institutions are regulated, which raises their credibility and reputation in the market and, in itself, instills confidence and trust among borrowers. Moreover, regulated lenders also provide financial guidance to their potential clients, outlining several ways to better manage their investments, loans, and other obligations. Given that only 27% of India’s adult population is financially literate, such assistance becomes essential to ensuring robust financial health and stability.

4. Building Credit History

Applying for formal loans can help build a credit history and improve credit scores. When borrowers consistently repay their loans, it enhances their creditworthiness and enables them to access future loans at more amenable terms. This, in turn, empowers individuals and businesses to undertake significant financial decisions, such as purchasing homes or scaling businesses, which ultimately contributes to driving India’s growth story.

Why Choose Protium to Avail of Loans?

Catering to a diverse cohort of MSMEs and consumers, our financial institution offers an array of credit offerings such as business loans, loans against property (LAP), and equipment finance, regardless of their credit history and loan size.

Our proprietary platform, Turiya, goes beyond credit scores and analyzes your transaction data, bank statements, and cash flows to get a holistic picture of your creditworthiness. Accordingly, Protium sanctions tailored loans ranging from small-ticket-size loans of Rs. 10,000 to massive business loans of Rs. 5 crore.

Moreover, individuals and businesses can engage with us both digitally over the web and via our Protium App, as well as at our physical branches. Engaging with formal lending institutions like Protium can help borrowers give wings to their ambitions, achieve financial empowerment, and enhance financial stability.