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Peer to Peer Education Loans

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This page discusses peer-to-peer education lending. Peer-to-peer lending, also referred to as social lending, person-to-person lending, microfinance and microloans, is a nontraditional form of lending involving unsecured loans between individuals. This is in contrast with traditional lending, where a bank or other financial institution makes loans to individuals.

History

Many peer-to-peer lending sites claim to draw their inspiration from Muhammad Yunus, the founder of microfinance. Muhammad Yunus established the Grameen Bank in 1974 to make small loans to poor families in rural Bangladesh. These small loans, often just $10 or $20, helped these families start small businesses and break the cycle of poverty. Over the three decades since its founding, Grameen Bank has lent nearly $6 billion to more than 6 million borrowers. Muhammad Yunus and the Grameen Bank were awarded the Nobel Peace Prize in 2006. (For more information about Grameen Bank, see Muhammad Yunus, Banker to the Poor: Micro-Lending and the Battle Against World Poverty, 2nd edition, October 2003.)

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Other early micro-lending organizations include Opportunity International, founded by Stefan Stojkovic in 1971, and the Foundation for International Community Assistance (FINCA), founded by John Hatch in 1984.

The connection between peer-to-peer lending and microfinance is tenuous. Micro-credit is focused on providing small loans to poor individuals. Peer-to-peer lending is focused on enabling larger loans between individuals. However, some forms of peer-to-peer lending involve combining many small loans from several strangers into a larger loan using a many-to-many or many-to-one model instead of a one-to-one model.

As of early 2008, peer-to-peer lending is in its infancy, especially for education loans. According to Celent, a research firm advising financial institutions, outstanding peer-to-peer loans of all types totaled $118 million in 2005, $269 million in 2006 and $647 million in 2007. According to the Wall Street Journal (Loan Web Sites Tapped for College Cash, April 29, 2008; Page D6), education loans represent less than 2% of Prosper.com's $135 million in outstanding loans. It is also unclear what percentage of the prospective borrowers are eventually funded.

The low volume of education loans at peer-to-peer lending sites is partly due to the short-term nature of peer-to-peer loans, which typically require short repayment terms ranging from 1 to 3 years. Traditional student loans have a longer-term horizon of 10 to 30 years as well as other terms customized to the need of students, such as in-school deferment of repayment. This has lead to the development of peer-to-peer lending sites that focus on education loans, such as Fynanz and GreenNote.

Currently there are a variety of different peer-to-peer lending models. The novelty of the field is leading to a lot of innovation. For example, Fynanz requires borrowers with an in-school deferment to make $25 "good faith" monthly payments. This helps maintain current borrower contact information and provides an early warning of default. It may reduce default rates by getting borrowers into the habit of making monthly payments. It also reduces borrower costs by reducing the amount of interest capitalization. In contrast, most borrowers of private student loans choose to defer payments of principal and interest during the in-school period.

Peer-to-peer lending sites may offer one or more of the following services:

  • Documentation of loans. This includes paperwork, such as fully executed promissory notes.
  • Servicing of the loans. This includes collection of payments and reporting the payments (or delinquencies) to credit reporting agencies.
  • Matching borrowers with investors.

Peer-to-peer lending sites typically fall into two main types:

  • Friends & Family. These sites provide formalized documentation of a loan (e.g., a properly executed promissory note) for a fixed fee. They may also provide servicing (collection of monthly payments) for a percentage of the outstanding balance. The interest rates on these loans are usually lower, sometimes competitive with the interest rates on government education loans.
  • Stranger-to-Stranger. Also known as person-to-person loans, these sites match lenders with unrelated borrowers. Not only do they document the loans, but they also service the loans and sometimes provide a guarantee against default. Usually these sites have minimum credit criteria. The interest rates are usually higher, sometimes competitive with the interest rates on private student loans.

Advice for Borrowers

Borrowers should focus on federal first, as federal education loans are cheaper, more available and have better repayment terms. Peer-to-peer lending should only be considered as an alternative to private student loans, and also more expensive forms of credit such as credit cards. Federal education loans are cheaper, more available and have better repayment terms.

Potential advantages of peer-to-peer lending over private student loans include:

  • Avoid the need for a cosigner. Peer-to-peer lending does not generally involve a cosigner, so if you are unable to obtain a private student loan because you don't have a cosigner, you might be able to obtain a peer-to-peer loan.
  • More personal. With peer-to-peer lending, the borrower often gets to make a personal argument for why he or she deserves a loan. This avoids the need to interact with large impersonal lending institutions.
  • Lower credit scores. The minimum credit score on a peer-to-peer lending site may be lower than the minimum required for a private student loan. For example, Prosper allows borrowers with credit scores as low as 520 to post loan listings.
  • Fixed rates. While most private student loans offer variable rates, peer-to-peer lending sites offer fixed rates that won't change over the life of the loan.
  • More flexible. An education loan from a peer-to-peer lending site may allow you to spend the money on more than just the college's cost of attendance. (However, if the loan is used for amounts beyond the cost of attendance, the interest is not eligible for the student loan interest deduction and the loan may be subject to bankruptcy discharge.) The money goes directly to the student, not the school. On the other hand, some peer-to-peer loans may offer terms that are not a good match for education financing, such as a shorter repayment term and the lack of an in-school deferment.

It is important to recognize that a peer-to-peer loan might not get fully funded, or funded at all. Except at friends and family sites, where the lender has a vested interest in the success of the borrower, the lenders are focused on obtaining a reasonable return on their investment. If the borrower asks for too low an interest rate or too much money, they might not attract any lenders. (Some of the peer-to-peer lending sites have imposed a structure on the transactions to avoid these problems. While this increases the likelihood of a borrower getting money, it also prevents competition from driving down costs for borrowers.)

Some of the peer-to-peer lending sites let the borrowers provide some background on why they need the money. Often this information is structured, providing information about the degree program, year in school, name of the college and GPA. The borrower's name and contact information is not disclosed to protect their privacy. In some cases the borrowers can post a message to the prospective lenders to tell them how they will use the money, and may include a photograph and recommendations from friends. Part of the attraction of peer-to-peer lending is getting to know the person to whom you are lending. It's not just about lending money and earning a return on your investment, but knowing that you are making a difference in people's lives.

Peer-to-peer loans between family members are unlikely to satisfy the IRS requirements for a qualified education loan as defined in 26 USC 221(d)(1). This means that the interest paid on these loans will not qualify for the student loan interest deduction and the loans will not be excepted from discharge under the US Bankruptcy Code (11 USC 523(a)(8)).

Advice for Lenders

The typical peer-to-peer lender does not have much experience evaluating risk, and so may not fully appreciate the impact of risk on the potential returns on investment. Considerations include calculating the risk-free rate of return, the need to diversify the investment and the lack of liquidity. Peer-to-peer lenders can lose their entire investment if the borrower defaults.

Risk-free rate of return. Lending $10,000 with a 10% interest rate may sound like a much better deal than a bank CD, but the bank CD is insured by the FDIC and the peer-to-peer loan is not. If the peer-to-peer loan has a 10% risk of default and a 3-year term, the equivalent risk-free rate of return is 2.24%, much lower than the 10% nominal rate. If the peer-to-peer loan has a 10% risk of default and a 10-year term, the equivalent risk-free rate of return is 7.54%. This better return on investment is because the risk of default is amortized over a longer term. Depending on the default rate and the loan term, peer-to-peer loans may pay better or worse than other investments, such as bank CDs.

The Peer-to-Peer Lending Calculator helps lenders evaluate the impact of the risk of default on the returns on investment. It calculates a risk-free rate of return from the loan balance, interest rate, loan term and default rate.

Diversification. If a lender invests all his funds in a single borrower and that borrower defaults, the lender has lost all his money. It is better to spread the money out over several borrowers to minimize the impact of any one borrower defaulting. None of the peer-to-peer lending sites provides automatic diversificiation across borrowers, so lenders have to do that manually. Some sites provide tools to make this easier.

FinAid recommends:

  • Spreading out the investment over at least six borrowers, and preferably at least fifteen borrowers. If you divide your investment among six borrowers and one defaults, you've lost only 16.7% of your investment. If you divide your investment among fifteen borrowers and one defaults, you've lost only 6.7% of your investment. Increasing the number of borrowers decreases the possibility of bad luck causing you to lose a disproportionate share of your investment.
  • Limit the amount invested in each loan, so that the magnitude of the potential loss is also limited. This will reduce the emotional impact of a default. Most peer-to-peer lending sites have a low threshold of $25 to $100 per loan, making it easier to get started.

Unknown Risk of Default. Because peer-to-peer lending is in its infancy, it does not yet have long-term default rate statistics. Some proponents of peer-to-peer lending argue that the personal connection between borrowers and lenders may lead to better repayment and lower default rates. It seems likely that peer-to-peer lending may eventually have similar delinquency and default rates to private student loans since the loans are made to a similar population. This is especially true for peer-to-peer lending sites that establish similar credit score cutoffs to private student loans (e.g., FICO score thresholds that eliminate exposure to subprime borrowers). However, some analysts argue that peer-to-peer lending may have higher default rates and higher delinquency rates than private student loans, since the borrowers may self-select to those who were unable to obtain a private student loan. Since education loans usually provide a deferment of payments of principal and interest while the borrower is in school (and for a six month grace period after the borrower graduates or falls below half-time enrollment), it may take some time before a delinquency becomes evident.

In addition, peer-to-peer loans typically do not have any collateral, so if the borrower defaults or files for bankruptcy, you may have limited or no recourse to recover your investment.

The bottom line is that the long-term risk of default is unknown. Investors who are considering making peer-to-peer loans should treat it as though it is a high risk investment. Do not invest more than 5% of your savings and investments in peer-to-peer loans. There is a possibility that you could lose your entire investment.

Illiquid Investment. There is no secondary market for buying and selling peer-to-peer loans. This means that if you invest in a 10 year loan, you will probably have to wait the full 10 years in order to obtain full repayment of the loan. Eventually a secondary market will develop, but it is likely that you will have to sell the loans at a discount, possibly as much as 20% under the par value of the loans. Until then there is no exit strategy for these investments. So don't invest money you might need suddenly. Be sure to keep some money in liquid investments such as money market accounts, savings accounts and short-term bank CDs.

Prepayment Risk. If a borrower defaults, not only is the investor losing the principal balance of the loan, but also future payments of interest. Even if the peer-to-peer lending site provides a guarantee against default, that guarantee only covers the outstanding principal balance (and in some cases only part of the principal balance). The lender will not receive any further interest from the borrower after the borrower defaults. (Even if the borrower doesn't default, these loans do not have a prepayment penalty, so there's nothing to prevent a borrower from paying off the loan early. This may reduce the overall return on investment.)

As noted above, peer-to-peer loans between family members are not considered qualified education loans and accordingly are not excepted from discharge under the US Bankruptcy Code (11 USC 523(a)(8)). This means that if the borrower files for bankruptcy, the family member who lent the money may lose the entire investment.

On the other hand, peer-to-peer education lending is an investment in helping students pursue their educational and career aspirations. It may provide more satisfaction than other forms of investment, since the lender is doing well by doing good. It's not just about earning a return on your investment, but about helping people, so some losses due to default are to be expected.

Peer-to-Peer Lending Sites

Peer-to-Peer Lending Sites
P2P Site
(Eligibility)
Limits Rates Fees Term
Fynanz
(640 min FICO)
$2,500 to $20,000/loan

$40,000/year

Aggregate:
$120,000 undergrad
$160,000 grad

1-month LIBOR plus margin of 3.5% to 7.9% and a 1% guarantee fee Borrowers: 2.9% to 6.9%
Lenders: 1% annual
5-10 years
GreenNote
(Friends & Family)
$1,000 to COA 6.8% fixed
(6.0% in PA and DC)
Borrowers: $49 or 2%
Lenders: 1% annual
10 years
Lending Club
(640 min FICO)
$1,000 to $25,000 7.37% to 18.86%
average 12.3%
Borrowers: 0.75% to 2.0%
Lenders: 1% annual
3 years
Loanio
(569 min VantageScore)
$1,000 to $25,000 7% to 24% or more Borrowers: 2% to 3% origination ($95 min) depending on credit score, plus 1% for a co-borrower
Lenders: 1% annual servicing
Up to 60 months
Prosper Marketplace
(520 min FICO)
$1,000 to $25,000 7.9% to 31.88%
average of 26.1%
AA average of 13.4%
Borrowers: 1% to 3%
Lenders: 1% annual
3 years
Virgin Money USA
(Friends & Family)
Not specified Not specified Loan Documentation: $199 for a single-loan promissory note, $299 for the ability to add up to 10 loans to the original promissory note.

Loan Servicing: $9 per payment.

Not specified
Zopa USA
(640 min FICO)
Not specified 12.5% to 18.0% Not specified Up to 60 months.

In addition to these sites which lend to US students, QiFang is focused on providing peer-to-peer loans to Chinese students who want to go to college.

Microfinance Lending Sites for the Poor

There are several peer-to-peer lending sites that enable investors from the US and other industrial nations to lend to entrepreneurs in the developing world. The loans are typically in very small amounts, from $10 to $20 or so to several hundred dollars. These sites argue that they are an effective tool for ending poverty by providing a hand up instead of a handout. The sites include:

  • Kiva, a 501(c)(3) charitable organization, is a person-to-person microlending site that facilitates lending to entrepreneurs in the developing world. Loans are short in duration (typically 6-12 months) and in small amounts (a few hundred dollars). The Kiva site is focused primarily on helping the working poor, although the default rate on "ended" loans is 1.3%. About one-third of loans are in an "ended" status.

  • MicroPlace is also focused on ending poverty by making small loans to the world's poor. MicroPlace was acquired by eBay in mid-2006.

A key concern about these microlending sites, however, has to do with the interest rates they charge the borrowers. While the lenders who provide the loan funds receive interest rates of 1% to 4%, the borrowers are charged a median interest rate of 30.9% according to the MicroPlace blog. The microlending sites argue that when the loans are smaller and shorter in duration, the transaction costs (including administrative overhead and servicing) represent a much greater percentage of the loan balance, leading to higher interest rates. Nevertheless, the interest rates are usurious and one can't help but worry that these microfinance sites are exploiting the poor.

Other Resources

The Peer-to-Peer Lending Calculator helps lenders evaluate the impact of the risk of default on the returns on investment. Given some details about the loan and the risk of default, it calculates a risk-free rate of return.

See also Education Investments and Student Sponsorships, where the investors are providing grants to the students either for the good of the community or for a percentage of the student's post-graduation income.

See also Loan Comparison Sites, which are sites that compare the terms of traditional federal and private student loans.

Predictions

Some colleges may establish peer-to-peer lending marketplaces which permit the college's alumni to lend to the college's current students.

 

 
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