Apparently they found recent grads with very large student debt load but commensurately high future earning potential had inaccurately low credit scores. Bypassing the credit agencies and doing their own scoring let them offer more competitive rates to that segment in particular, whose big loans probably carry a lucrative underwriting fee, not to mention bigger savings for every basis point you can shave off.
Interestingly they are underwriting as well as servicing ("Earnest will never pass you off to a Third-Party Servicer") which I see as a huge selling point. I wonder how hard it was to get the Federal approval for that?
Yikes, that's a bit scary. The dark side of me wonders if there is anything untoward that happens here, in that they can pull money from any of these accounts? That's a LOT of information to be handing over, more than when I applied for my mortgage (especially compounded by the fact that this sounds like an on-going monitoring of these accounts), and I'm not sure I'd feel comfortable with it.
They would know everywhere I've shopped, every single bill I have, every cash withdrawal. I don't know that I want any entity knowing the totality of my finances like that, regardless of whether I'd want a couple of percentage points off of interest (especially considering the historic lows of interest rates right now).
Credit scores measure the risk of future default based on past borrowing behavior. A borrower's credit score is not "inaccurately low" if there is little to no past borrowing behavior to apply the credit scoring model to.
Lenders can and frequently do take into account criteria other than credit score, such as income, when underwriting loans. In some lending markets (mostly commercial), individual consumer credit scores aren't even used.
That Earnest and other upstart lenders are choosing to more heavily weigh factors other than credit score is not particularly interesting. The true test of their underwriting criteria will come in the next down cycle. Having worked in this space, I should point out that there are many consumers with high incomes (or high earning potential) who are vulnerable. As such, I'd suggest that income and earning potential alone are of limited use in underwriting. It's not uncommon to see borrowers with high incomes who also have very low credit scores because they were over-leveraged and had serious negative credit events occur.
They are mining more information and winning a lower rate for it. To that end they are succeeding. Without understanding the source of funds, and any guarantees they are making, it's important that they provide long-term durable ROI to justify the lower rates.
If they get the lower default rate they are paying for, then Earnest has created a superior product. Their default rate doesn't and shouldn't have to be zero, but I would be afraid of trying to make up on bad underwriting with poor servicing tactics. I hope both centers are striving to be excellent at their respective jobs.
Since default rates on these loans is high and rising, there is a strong incentive to lower it. If default rates were consistently low, paying more for a marginal additional reduction wouldn't be worthwhile. When default rates are trending higher, I believe you need exponentially higher interest rates in order to break even.
And there are lots of reasons not to refi federal loans to private loans to save a bit of interest, particularly IBR and pay-earn plans. Though private loans would be dischargeable in bankruptcy, so they have that going for them.
Did I read that right, refinanced / private student loans are dischargable in bankruptcy?
Does SoFi also service the loan? It's not clear from their landing page. Side-by-side I think Earnest has done a much better job on their site as far as promoting their technology and differentiation.
Certainly that's enough of a spread to make money, but it doesn't seem like some huge opportunity. FWIW I scratch my head for the same reason about mortgages given the narrow spreads, but there companies don't actually plan on holding the loans on their books (most end up on some set of government books in recent years). So that's more of a services volume business than it is an underwriting one.
Edit: I just re-read this and I made a mistake. The 3.6 and 4.6 are above the 10 year treasury which is around 2.3. So the spread between the AA rate and the loan is 290 to 390 bps not 60 to 160. A considerably better situation.
Before people read the headline and think "OMG another big one", this line is important. They are raising $75MM for the company and $200MM for the actual financing of the loans.
For anyone not familiar with SoFi (the main competitor), this model makes a ton of sense. Student loan terms do not take into consideration your future earnings based on what school you attend. Which means someone who goes to Harvard could have the same student loan structure as someone who goes to Foo State College. This is simple arbitrage.
