After graduating from Princeton in 2003, Louis Beryl took a job in New York City trading energy derivatives. While his new employer, Morgan Stanley, promised to reimburse his relocation expenses, he needed $8,000 to front the costs of the move--not the sort of thing a 22-year-old with little credit history could get a bank loan to cover. So Princeton's financial aid office lent him the money at 7% annual interest for five years. He paid it off six months after graduation.
Six years later he needed to borrow again, this time to finance the M.B.A. and master's in public policy he was earning at Harvard. He took $20,500 a year in student loans from the federal government at 6.8%, but beyond that, Uncle Sam wanted 7.9%. Commercial banks, despite Beryl's six years of prompt bill payment, demanded double-digit interest and his mother as a cosigner. Instead, he borrowed at 4% through his mom, who tapped into her home equity line.
"I knew in my gut how low-risk I truly was,'' says Beryl, who had saved for grad school while working. But banks weren't interested in looking at evidence of his thrifty behavior or at his future earning potential.
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Which turns out to be a good break for the now 34-year-old Beryl, who is the cofounder and CEO of online lender Earnest. Despite its down-home name (and Beryl's resemblance to a young Garrison Keillor), Earnest is one of three startups, all backed by sophisticated investors, that aim to use fancy algorithms and novel information sources to make small loans to young folks with thin conventional credit files--too thin, that is, to borrow at reasonable rates, if at all, from the banks. Credit Karma, a free credit-tracking service, reports that 7.5% of its more than 30 million members have thin files.
The venture capital firms that put up $15 million last May to launch San Francisco-based Earnest include Atlas Venture, Collaborative Fund, First Round Capital, Maveron and Andreessen Horowitz, where Beryl worked for a year and a half after Harvard. Palo Alto-based Upstart was founded by two Google veterans and Paul Gu, a 24-year-old who dropped out of Yale to take a fellowship funded by billionaire Peter Thiel. It has raised $20 million from Google Ventures, First Round Capital, Thiel's Founders Fund, Kleiner Perkins and Khosla Ventures. New York City-based Pave is funded by angel investors and plans to seek venture capital and possibly private equity money this year.
Upstart and Pave offer individual accredited investors the chance to fund loans (see box, p. 56) , an approach that Beryl says he has rejected because it gets in the way of putting the interests of borrowers first.
Earnest goes beyond the conventional credit reports banks get from Equifax, Experian and TransUnion to crunch big data--80,000 to 100,000 data points per applicant, collected in large part by linking directly to an applicant's bank and credit card accounts and downloading a full history, including deposits, withdrawals, balances and payments. That compares with the 500 to 1,000 data points that Credit Karma estimates are in a typical 25-year-old's credit file, which forms the basis for the FICO score from Fair Isaac used by most banks.
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A traditional credit score considers whether an applicant paid his credit card bills, mortgage and other bank loans on time, but it doesn't always capture prompt payment of rent and doesn't consider earnings or education. In contrast to FICO, Earnest, with its deep data access, factors in not only whether an applicant makes timely payments on his credit cards but also whether he pays the minimum or in full each month, giving more brownie points to the latter. It also considers rent payments and earnings potential, diving into an applicant's education and employment background and prepopulating that history on a loan application by linking directly to the applicant's LinkedIn account.
"This is all about FICO and the other credit scoring companies failing to keep up with the times," says Brendan Ross, president of Direct Lending Investment, which runs a $115 million fund that allows accredited investors to fund direct small-business loans. "If the credit scoring companies could add all this data themselves, then Earnest wouldn't be able to add value to it in a way that is cost-effective enough to make loans at very low rates."
In exchange for all this data, which Millennials seem to have fewer qualms than their elders about sharing, Earnest offers people with short credit histories unsecured loans of $2,000 to $30,000 at rates of 4.25% to 9.25%, for one to three years, with no origination fee.
Jasmine Knowles, 25, applied for a one-year $3,000 loan late last May, as she was finishing up a two-year University of Pennsylvania program in which she earned a master's in education while working in Teach for America. She wanted the cash to travel to Peru and Bolivia during a two-month break before beginning a well-paid management consulting job. "I liked their business model and that they rewarded people who consistently strive to do great things,'' says Knowles, who was approved in eight days for an Earnest loan at 5.5%, the lowest rate it then offered. That was more than a percentage point less than the best rate offered by peer-to-peer lending sites Lending Club and Prosper and less than a third of what Knowles would have paid had she financed her travels on her credit cards.
Knowles isn't likely to need such a tiny advance again. But Beryl clearly wants to build a longer-term and deeper lending relationship with the bank-wary Millennial generation. While Earnest had just $8 million in loans outstanding at the end of 2014, it is aiming to make hundreds of millions in loans this year. Two other startups, SoFi and CommonBond, have been making inroads with young borrowers by refinancing student loans, which seems a logical next place for Beryl to take his big data approach, given the $1.3 trillion in student debt outstanding.
Each of the three small loan startups is cracking lending's inefficiencies to serve a slightly different slice of the roughly 20-to-35 age demographic. Earnest, focused on the best risks, says its typical borrower earns just over $100,000.
Upstart lends to the widest range, and its rates on three-year loans of up to $25,000 vary accordingly, starting at a 5.7% APR but topping out at a hefty 30% APR, including an origination fee of up to 6%. Its algorithm uses both credit bureau information (it won't lend to those with a FICO score of less than 640) and factors like the college a prospective borrower attended, GPA and SAT scores, and work history to identify folks it predicts are better risks than their FICO scores would suggest.
Pave, too, starts with conventional credit scores, requiring at least a 660, but then adjusts that score based on both educational history and its analysis of what FICO formu las get wrong. "There are a lot of things that FICO simply excessively penalizes or under-penalizes,'' says Pave cofounder Oren Bass, a 37-year-old British solicitor who last worked in Goldman Sachs' structured finance department. For example, he says, someone with limited credit history who hadn't maxed out his credit card but applied for a store card just to get a discount on a purchase would be excessively penalized by FICO. Pave's APRs on loans of up to $25,000 currently range from 6% to 16%, including a 2% origination fee. (It has been conducting a pilot in New York but plans to go nationwide soon, offering an even wider range of interest rates.)
The big question, of course, is whether these newcomers and their algorithms are really better at predicting how young borrowers will perform. "You have to keep in mind, [these companies] have really small portfolios. They're very new. Sometimes you don't peak on your defaults until month 12 to 24. It's really the second-year loans where you'll historically run into these things," warns Kenneth Lin, founder and CEO of Credit Karma.
At least some defaults are inevitable and, Ross points out, necessary for the newcomers to train their algorithms. "If you don't have any loans that have ever defaulted, then the temptation is to loosen your lending standards to add volume. You don't really know when to stop loosening standards,'' says Ross, who has been involved in peer-to-peer lending as both an investor and an analyst since 2011.
"With the right mathematicians and the right use of data,'' he adds, "it should be possible to beat FICO and to find the future 1% faster than traditional credit bureaus."
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