Peer Lenders: A Last Resort for Student Loans

Thanks to the credit crunch, dozens of student loan lenders, including the nation's largest, Sallie Mae (SLM), have either dramatically cut back on their offerings or have stopped offering loans altogether. As a result, a growing number of students are turning to peer-to-peer lending sites like Prosper.com and LendingClub.com that facilitate loans between strangers, allowing a cash-strapped consumer to find a willing lender to loan them money.

The attraction for borrowers: Interest rates can sometimes beat out those offered by private student loan companies, and there are usually fewer fees and restrictions. For lenders, it's a way to simultaneously earn a decent rate of return on their cash and help someone in need. "It's an interesting concept, the idea of investing in an individual student," says FinAid.org publisher Mark Kantrowitz, who is considering adding a peer-to-peer lending page to his financial aid information site.

The growing interest in peer-to-peer student loans has even given rise to two web sites focused solely on education debt: Fynanz.com and CollegeDegreeFund.com. Social finance site Zopa.com plans to launch a student loan feature in July (right now, student borrowers apply for a personal loan). At this point, however, students are still a minor market for social lending, which is typically used for loans to pay down debt or launch a home business. At Prosper.com, for example, education loans account for less than 2% of its $135 million in loans.

But before turning to a peer-to-peer lender, students should exhaust all other funding options first. "[These sites] are not set up to be student lenders," says Lawrence Glazer, a managing partner at Boston-based investment firm Mayflower Advisors. "There are still more than enough private lender players out there to get people the money they need for college," says John Pearson, a CPA and certified college planning specialist based in Norwalk, Conn.

Even the sites themselves admit that they're not the first place borrowers should turn to. "Federal loans are still the way to go," says Prosper CEO Chris Larson. Fynanz won't even accept applications from borrowers who haven't first tried to get loans by filing a Free Application for Federal Student Aid.

Here are four things to consider before you seek tuition money on a peer-to-peer lending site: