The Latest Twist in Student Loans

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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 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. 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.