NEW YORK (MainStreet) —Student loan debt almost tripled between 2004 and 2012, and nearly one third of borrowers in repayment are delinquent. Against this backdrop, several companies are seeking to tap new sources of funding for college tuition that they say have more than a financial interest in the success of their recipients. Could part of the solution to the student debt problem lie in notions of community, mentorship and the freedom to follow your dreams?
When a team of Stanford business school graduates created SoFi in 2011, they sought to humanize education finance. Their product allows college alumni to invest in funds that lend to students or recent graduates of their alma mater at a lower fixed rate than is available from other unsubsidized sources. “We are tying people who have a real reason to behave well with each other in order to remove all the bad incentives that can occur when you have a faceless mega-corp lending money to individuals,” said Adam Boyden, COO of SoFi. The company now offers financing at 78 schools.
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As students at Wharton Business School, the founders of CommonBond were surprised at the cost of the loans offered to them. “The Federal government charges the same rate to everybody, and private banks are still skittish coming out of the financial crisis,” said David Klein, Co-founder and CEO. At the same time, Klein and his collaborators saw potential in the affinity group of the university. “A lot of trust was lost between banks and consumers after the financial crisis, so the question becomes, 'What are the natural centers of trust?' And that will likely be the place that people flock to.”
CommonBond, which offers a similar product to SoFi’s, launched at Wharton in 2012 and is currently expanding across several schools nationally. For every degree fully funded on its platform, it funds the education of a student in need abroad for a year.
The companies' 10-year loans have interest rates below 6.4%, with further reductions for automatic ACH payments and no origination fee for refinancing customers. This compares to the Federal Direct PLUS Loan rate of 7.9% with a 4% origination fee.
Both CommonBond and SoFi emphasize the importance of the participation of alumni and help student borrowers to capitalize on the networking and mentorship support that investors can opt to contribute. “We’re providing students with an opportunity to connect with people who can advance their career, which in a lot of cases is worth even more than the $20,000 that students can save on our platform,” said Klein.
But given the early stage of the ventures, the benefits of their alumni communities are not yet reflected in their interest rates. And while they are among the investors carrying the greatest amount of risk, individual alumni are not the only participants in either company’s funds; capital comes from a variety of sources. Another notable characteristic is that obligations of MBAs currently account for the vast majority of SoFi loans and all of CommonBond’s portfolio. (CommonBond plans to expand across other graduate and undergraduate programs beyond 2013.)
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So is this model about bringing alumni to the table to help lower the cost of education, or has it simply identified an underserved market of high earnings potential borrowers who represent an attractive risk for many investors, regardless of their school allegiances?
For CommonBond and SoFi, the two go hand in hand.
“We’re interested in operating programs wherever we can generate enough interest from alumni, and the alumni who have a sufficient connection with their school are preponderantly from schools which have an historically very low default rate,” said Boyden.
Barmak Nassirian, an independent higher education analyst with more than two decades of experience in student lending issues, said he suspects the main benefit of alumni involvement is the marketing channel it opens. “But I’m not sure that they would have much of an advantage against giant lenders that can just be more efficient and that may not need any of the emotive tools or aspirations that they wrap around the program.”
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SoFi and CommonBond maintain that time will demonstrate that financial ties to alumni networks produce lower default rates among their borrowers than classmates who fund their education from other sources. “We’re highly confident we’ll do better than that cohort,” said the CFO of SoFi, Nino Fanlo. “And however much that helps will be passed on to borrowers.”
Investing in people
A second set of companies seeks to amplify the alignment of financier and student incentives in a way that they believe is not possible in a traditional lending relationship. As Paul Gu, Co-founder of Upstart put it, as a lender “your incentive is to say, ‘Please become an accountant or go work in a very stable job, and I really don’t need you to make a lot of money. I need you to make just enough to pay back the loan.’”
Upstart and its competitor Pave facilitate arrangements, under which backers agree to provide funding to an individual in exchange for a small share of that person’s income for 10 years. It’s a model that aims to allow funding recipients to be led by their passions rather than a paycheck early in their career. “A lot of us in the company had this issue, where you take a safe job, or you end up doing things you don’t love, because you have to start paying loans back,” said Sal Lahoud, Co-founder and CEO of Pave.
Pave and Upstart investors have the option to mentor their investees. “There’s the very unique ability to influence the trajectory of your investment by just offering occasional advice or making an introduction, which obviously you can’t do if you’re investing in large companies which you can’t move the needle on,” said Gu.
Nassirian has reservations. “It is very appealing, because it looks like such a radically, refreshingly different model; it pops up like clockwork every decade,” he said. But he warns that “the attempt to assess future income exposes you to all kinds of vicissitudes of the human condition that could wipe you out, either as a matter of choice or a matter of accident.” He points to the risk that an investee develops a degenerative illness, or decides to become a stay-at-home parent, or opts out of a remunerative career – risks that the person-to-person model has less capacity to absorb as a result of its concentrated exposures.
Of course, all that risk comes with a share in the upside, which extends to five times the original funding on Upstart’s platform and is unlimited with Pave.
And while backers stand to profit in line with the success of their investees, both companies said many demonstrate motivations that are not predominantly financial. Lahoud recalled, for example, a successful litigator who said, “‘Actually, I want to back people in fields that I love, that I haven’t had a chance to be in.’”
Allesandra Lanza of American Student Assistance, a private nonprofit that seeks to empower borrowers to manage their college debt successfully, said that individuals looking for breathing room also have options under the Federal student loan program, including in many cases the ability to base payments on discretionary income, or adopt graduated repayments.
Like all of the industry participants interviewed, Lanza thinks students need to weigh their future earnings potential at the time they embark on their education. “I think a lot of times students aren’t looking for that type of information. I think they go into it thinking that they’re going to deal with it when they get out of school," she said. "So we need to get people to start being more proactive and thinking long term."
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