Before some college-bound kids hit the books this fall, they may have to hit the pavement searching for cash.
Funds have become scarce as dozens of lenders have stopped providing new student loans or shuttered their doors entirely. That's because a new law cut federal subsidies, and the market for repackaged student-loan securities dried up amid the credit-market turmoil, making student loans unprofitable and unsellable.
Bank of America (BAC), JPMorgan Chase (JPM) and Citibank (C) all said they will halt some student lending this month. Loan guarantor The Education Resources Institute declared bankruptcy on April 10 due to market conditions. Sallie Mae (SLM), the country's top student-loan provider, said earlier this month that it can no longer earn profits on loans and that the market is heading for a "train wreck" in mid-2008.
Outlets that are still lending are especially averse to risk because of the mortgage-market collapse and worries about the health of the economy. That means students who were once eligible for loans might not be anymore, since standards have tightened dramatically. Lawmakers are working toward a bill that would allow the federal government to bail out student lenders by purchasing more of their debt, but it's unclear if that legislation will ultimately pass.
So how are some students shoring up college cash? Online, of course.
"Peer-to-peer" lending sites have allowed facilitated loans among users for years and may offer an attractive alternative to traditional loans. In many cases, borrowers outline the type of loan they are seeking -- including amount, purpose, duration and interest rate. Lenders review borrower profiles, photos and credit scores to choose a candidate, balancing the risks and potential returns. Then they bid on loans, usually in $25 or $50 increments, with higher demand leading to lower interest rates. Other P2P sites simply set an interest rate based on the borrower's credit rating. Usually, the sites earn money by attaching fees to their services.
For borrowers, the process can be simpler than dealing with the paperwork and headaches involved with traditional loans. It also has the potential for lower interest rates and allows those with weak credit profiles access to loans not otherwise available. For lenders, the sites can offer better returns than with other investments like CDs or money-market accounts, whose rates have become paltry. Alumni looking to help a struggling student from their alma mater or those seeking "socially responsible" investments might also favor these transactions.
The risks of lending on established P2P sites are similar to any other private, unsecured debt. The borrower's credit history, employment and student-status are verified; a legal promissory note is signed; defaults are reported to a credit agency; and collection agencies can be invoked. Some loans are even guaranteed. Plus, since many lenders are spreading out loans in small increments across several borrowers, risks are further mitigated.
For instance, a Prosper.com borrower with the user name "ladyinred1983" needed $8,300 to fund her final year of college. Her credit grade is an "A" and her debt-to-income ratio is 17%. She works full-time in retail and earns under $50,000 per year.
"My parents and I have gone three years without getting a loan, but now it looks like we need it," wrote ladyinred1983, who is working toward a Bachelor's in international business. "I plan to do many things with my degree," she added, "and do not want to flush three years of hard work and a 3.6 G.P.A. down the drain."
At last glance, her loan was fully funded after 260 potential lenders bid down her interest rate to 12.7% from 16.09%. Most of the bids were in $50 increments.
Celent senior analyst Edward Woods, who has researched P2P lending, warns that because the sites are relatively new and loans will take many years to pay off, only time will tell how they fare. However, statistics show that default rates on P2P lending sites are lower than industry levels. Some also argue that "self-policing" on the sites -- where users create personal connections through photos and stories of financial struggle -- mitigates some of the risk further.
"Now you're defaulting on an individual vs. an institution," says Woods. "That seems to be a motivator and once you've made a mistake in this environment you're kind of tagged."
No one suggests that P2P sites will replace the Sallie Maes of the world, but at least one start-up called Fynanz.com is hoping to make the most of recent market turmoil. The pure-play student lending site launched in mid-March and has about 200 members, adding 15 to 20 per day. Fynanz acts as an intermediary between the two sides. It provides the loan to borrowers, then sells portions of it to the lenders while earning fees on both ends.
Fynanz is currently testing out its product in seven states and hopes to roll it out nationally in coming months, says Founder Chirag Chaman. He hopes the site will not only be a successful business, but will prod students to learn more about borrowing as they are required to structure terms of the agreements.
"People say to me, 'Well, there's a big crunch in the student loan arena,' and I say, 'Well, not really,'" says Chaman, who has a background in structuring student loans for Smith Barney. "This crunch is not lack of cash, this crunch is on lack of education."
More P2P sites besides Fynanz are also cropping up: At least two, called Lendary.com and Loanio.com, are on the horizon. Woods expects the overall P2P lending market to grow from $282 million in 2006 to over $5 billion in 2010. The credit-market turmoil and added woes for the student-loan market can only enhance its potential, he adds.
"This could spread like wildfire," says Woods. "Natural business rules dictate that they will get more demand. People will still want to go to school despite the credit crunch."
A look at Fynanz and some other P2P lending sites, as they pertain to student loans:
Description: Fynanz.com is strictly for student loans. Borrowers post their requirements and lenders sort through listings to bid on loans that offer the most attractive risk-reward balance.
Fees: Borrowers pay an upfront fee, which varies from 2.9% to 6.9% based on their credit scores. Lenders pay an annual 1% servicing fee, which can be postponed if a loan is in deferment.
Pros: Students can set the rates and terms, and credit bureaus are not informed of the loan until the rate is set, a deviation from standard practice, according to Chaman. Borrowers can opt out of a loan within 30 days. In addition, the interest rate drops one percentage point as soon as 10% of the original loan has been paid.
Lenders benefit from loan guarantees and repurchases, which are not offered on competing sites. The least risky loans, which have lower interest rates, are completely guaranteed. As the risk level and interest-rate increases, so does the guarantee coverage. For those who don't want to hold onto the loans until they're paid off, Fynanz will periodically offer to repurchase loans.
Cons: Since the site is new there are few users to lend to or borrow from. Terms for some features, like repurchases, are also unclear as the site works through its testing phase.
Description: Launched in February 2006, Prosper.com's structure is similar to Fynanz, except it can be used for all types of loans.
Fees: Borrowers pay a closing fee of 1% to 3%, based on credit grade, or a $25 flat fee, whichever is greater. There are also fees for using outside electronic payment services and for late or delinquent payments. Lenders pay an annual loan servicing fee of 1%. There are additional fees for collection agencies, when required.
Pros: Lower upfront fees for borrowers, more lenders and more listings to browse through.
Cons: Currently, there are no guarantees on loans.
Description: Earlier this month, LendingClub.com -- another one of Fynanz's predecessors -- posted a notice that it would not be accepting any new lenders until it registers its promissory notes with securities regulators. Ordinarily, the site is structured similarly to Fynanz, but can be used for all types of loans, and interest rates are fixed instead of auctioned. Rates range from 7.37% to 18.61%, based on credit grade. Borrowers can continue to request loans, but those posted after April 7 will be "funded and held only by Lending Club."
Fees: Borrowers pay a processing fee of 0.75% to 2%, based on credit grade. There are also fees for missed or late payments. Lenders pay a 1% annual processing fee as well as collection-agency fees, when necessary.
Pros/Cons: Though the site offers low processing fees for borrowers, it is unclear what's going on with its securities registration process. Lending Club is in a "quiet period" until the process is complete, leaving the implications unclear.
Description: Zopa partners with local credit unions to offer CDs and loans with a twist: Every customer who buys a CD must help at least one borrower with their monthly payments. They do this by apportioning a certain amount of their yield toward one or more borrowers' payments, called a "help." The more altruistic they are, the less return on investment. Zopa launched in the U.S. in December and also operates in the U.K., Italy and Japan.
Fees: As long as consumers are paying electronically and on time, no fees are assessed. Zopa earns cash primarily from the credit unions for servicing loans and CDs. Interest rates for borrowers start at 8.49% initially.
Pros: For borrowers, the Zopa concept is ideal: Their loan can, in theory, be paid entirely by other members. For lenders, their investments are guaranteed and insured by the government and can satisfy socially responsible investment theories.
Cons: Returns are not necessarily the best. The recent rate on a Zopa CD was 3.75% for a one-year deposit of at least $500, before subtracting the "help." That compares with an average 3.65% return on one-year CDs at the top 10 banks.
Description: VirginMoneyUS.com does not actually provide loans or link up lenders and borrowers. Instead, it services debt among family members or friends. The entity, part of Richard Branson's Virgin Group, offers documentation, a repayment schedule, reminders and online banking transfers.
Pros: This kind of "official" repayment schedule with a loved one places more responsibility on the borrower than a handshake. It also comes without awkward discussions of when payments are due and how much is owed.
Cons: It's a lot to pay for a lack of gumption. For student loans, Virgin Money charges $299 to document and service the loan, plus a $9 fee per payment for up to 10 uses. There are "handshake packages" for personal loans that come cheaper, at $99 and $199. Instead, there's always the option of sucking it up, figuring out terms and a payment schedule and sticking to it on your own (for free).