As traditional sources such as banks and government agencies pull back, peer-to-peer lending is entering the student loan market
Because of the credit crunch, conventional lenders are making it tough for any but the most creditworthy borrowers to qualify for private college loans. Now, a new breed of student lender is trying to get students to return the snub—by writing off the Sallie Maes and Citibanks of the world in favor of relying on friends, family, and even perfect strangers to finance their college loans. "It's not a solution to the credit crisis in student loans by any means," says Mark Kantrowitz, publisher of financial aid Web site finaid.org. "But the idea of using peer networks to raise money is intriguing."
In recent months, peer-to-peer lending sites (BusinessWeek, 4/23/08) such as Prosper and Virgin Money USA have introduced student loans or started marketing existing offerings to families looking for college funds. Others, including startups GreenNote and Fynanz, are focused exclusively on making college loans. Analysts say the sites are benefiting from the confluence of trends—a growing acceptance of peer-to-peer lending and fallout from the credit crunch, which has caused lenders who account for more than 20% of the market for private student loans to stop lending.
The general idea is to facilitate loans between students, on the one hand, and either Good Samaritan friends and relatives, or strangers intent on investing in alternatives to stocks, bonds, and certificates of deposit. The sites take very different approaches, though. Some, such as Virgin and GreenNote, mainly seek to formalize loans between friends and family members. Others—Prosper among them—allow borrowers to publicize the amounts they wish to raise and the interest rates they're willing to pay. Then, lenders—friends or strangers—bid on funding even a small portion of these loans. As the competition among bidders intensifies for a piece of a loan, the interest rate a student will have to pay declines.
A Win-Win Setup
It sounds like a great idea. For individual lenders, the loans are promoted as a way to earn a decent rate of return while helping a student in need. For borrowers, the allure is the prospect of securing an interest rate that's lower than the 6% to 16% that conventional lenders charge for private loans. (Interest rates on private loans depend mainly on credit scores.) "The idea that you can get people bidding down the interest rate on your student loan is certainly attractive," says Kantrowitz.
There are also plenty of potential drawbacks. For lenders, the risks are difficult to gauge. Indeed, many peer-to-peer sites say it's too soon to know what percentage of borrowers will ultimately default on their loans. While lenders can reduce the risk of a loss by carefully vetting borrowers, lending in small doses, and spreading their money among several borrowers, a loan portfolio with an average interest rate of 10% will net just 7.5% if 10% of borrowers default, says Kantrowitz. That's not unrealistic, given that 11.5% of Sallie Mae's private loans were delinquent in 2007. Some sites, including Fynanz and Zopa, offer lenders some degree of protection against losses. The trade-off, though, is lower returns.
For borrowers, the big question is whether the sites will help make loans more plentiful. Currently, most peer-to-peer lenders report low lending volumes. At Prosper, for example, only 2% of the $150 million in loans arranged so far are for education. Moreover, the terms on some of these loans may prove unattractive. Some lenders, for example, require students to repay loans over relatively short periods. Not all of them will grant postponements until after graduation. Moreover, the fees on these loans can be high. And because there's no guarantee of landing an attractive interest rate, it's important, as always, to shop around.
Before borrowing from any of these sites, be sure to exhaust the amounts available under federally backed loan programs. With a maximum fixed interest rate of 6.8%, the Stafford Loan for students is almost always less expensive than a private loan. The downside: These loans limit undergraduates to a cumulative amount. But families can borrow more—up to the full cost of attendance—under the federal PLUS Loan program for parents. The current rate on a PLUS loan: a fixed 8.5%.
Here's a quick read on the various players in the market for peer-to-peer student lending:
Prosper: The site (prosper.com) fits students into its one-size-fits-all loan program—a three-year loan that borrowers must start repaying immediately. The site models itself after eBay (EBAY). Borrowers allow Prosper to pull their credit reports, verify their enrollment status, and assign them a risk measure that alerts lenders to the potential risk of default. The lenders bid on slices of the loan, with those willing to earn less interest driving down the rate on the loan. The site makes money on fees. Borrowers pay 1% to 3% up front, depending on their credit score. Lenders pay a 1% servicing fee each year.
Virgin Money USA: This site (virginmoney.com) formalizes loan arrangements between friends and family. While some 11% of the $300 million in loans it has arranged have been used to fund education, it only recently launched a product, called Student Payback, that's specifically for students. President Asheesh Advani touts the loan's flexibility: Payments can be postponed until graduation, he says. And "every year, for no extra fee, borrowers and lenders can change the payment schedule." Negotiated between borrower and lender, the interest rates are typically about 4% or 5%—or far below the 6.8% rate on federally backed Stafford Loans. A lender can sign over up to $24,000 a year without triggering a federal gift tax.
While many parents dig into their pockets to make loans, some take out home equity or Federal PLUS loans—and use the site to formalize a student's pledge to repay those amounts. "Parents are more apprehensive about retirement now. This really provides them with peace of mind," says Advani. Still, peace of mind doesn't come cheap. Up-front fees on the loans range from $199 to $299, depending on whether a student borrows once or multiple times. When a student graduates and begins to repay a loan, Virgin pockets yet another $9 fee per payment to service the loan.
Fynanz: Launched in March, the site (fynanz.com) makes students loans in seven states, including New York, New Jersey, and Massachusetts. By early 2009, CEO Chirag Chaman expects it to go nationwide.
For lenders, Fynanz takes some of the risk out of making loans. It guarantees repayment of anywhere from 50 cents to 100 cents on the dollar. The guarantees rise with a borrower's credit. It also requires borrowers to obtain co-signers, who become responsible for repaying loans that default. The site is picky about whom it selects: Currently, it turns away about 12 applicants for every borrower it accepts, Chaman says. "Our job is to reduce default rates."
The site offers some benefits to borrowers. By summer, it will launch a product that will exempt college juniors and seniors with credit scores of at least 640 from the co-signer requirement. And it shaves 1% off a borrower's interest rate once 10% of the loan is repaid. The site sets rates—which are variable and currently range from 5.6% to 10%—at auction. It charges lenders 1% a year to service the loans. Borrowers, who pay from 2.9% to 6.9% of the loan amount up front, max out at $120,000 as undergrads.
GreenNote: Currently available to students at 12 colleges, this program will officially launch in early June. The site (greennote.com) doesn't plan to require students to line up a more creditworthy friend or relative to co-sign its promissory notes. Nor does it plan to check borrowers' credit scores. "It's a platform that allows students to tap into their social networks. This can be friends, family, alumni of the same school, or friends of friends," says founder and CEO Akash Agarwal.
The site collects and transfers the amounts lenders contribute to schools. Students can postpone repaying these loans until after graduation. The interest rate is low—a fixed 6.8%, to conform to the maximum under the federal Stafford Loan program. "Lenders can choose to reduce or waive the interest at repayment, turning the loan into a gift," Agarwal says. GreenNote charges lenders a 1% documentation fee. Borrowers pay $49 or 2% of the loan, whichever is greater. The risk? If your network doesn't kick in all you need, you'll have to shop around for other loans.
Zopa: When a student or parent applies for a loan, the site (zopa.com) runs a credit check. Zopa charges no fees but interest rates can be high—some 8.5% to 17%, depending on a borrower's credit score. Where's the peer-to-peer angle? Borrowers can ask friends and family to purchase one-year CDs from the site. Those who do are required to devote at least 0.10% of the current yield of 3.75% to helping a borrower meet his or her monthly payments. Because some CD holders are willing to part with far more than 0.10%, a borrower may see his or her monthly interest payments wiped out. A few even pocket enough to help pay down principal. As with other CDs, these are insured against losses. And when they mature, the principal is returned to the investor. The loans, which must be repaid over five years, are capped at $25,000. This summer, the company plans to launch a student loan product with a longer repayment term.