When the online lender Social Finance recently unveiled its latest refinancing product, it put a spotlight on a perhaps overlooked corner of the student loan market: medical residents.

SoFi launched an offering in October designed specifically for medical school graduates who practice in a residency program at a hospital or clinic. The company is following in the footsteps of established players like Darien Rowayton Bank and several upstarts.

Yet the move is notable not only because of the disruption it could create in a once low-profile niche, but it also shows how lenders are trying to use data to mine untapped business opportunities right under their noses and pitch those credits to investors.

SoFi refinances the federally guaranteed and private loans of graduates with advanced degrees and high-paying jobs, offering them lower interest rates than they pay on their in-school loans.

Medical school students graduate with an average debt load of $190,000 but are typically paid no more than $60,000 a year during residency, a fraction of their eventual earnings potential. So the savings offered by refinance loans are extremely attractive. Yet their low incomes may disqualify them for standard refinance loans.

SoFi’s new product allows residents to consolidate their existing loans and make a single, $100 monthly payment during residency or fellowship. Full repayment starts once borrowers have completed their training; or up to 54 months. Repayment terms range from five to 20 years; both fixed and variable rates are available.

median debt of medical school graduates

Meron Colbeci, SoFi’s senior vice president of product management, said it was developed in response to customer feedback and data which showed that medical residents would not qualify for the company’s loans. “Residents did not have enough cash flow” to qualify, he said.

Because medical residents earn far less than a licensed and practicing doctor, SoFi projects future income to determine if a borrower has the ability to repay student loans upon completion of a residency program.

SoFi will have to square off against several competitors, however. There are already at least two refinance lenders that cater exclusively to medical professionals, including those still in residency: LinkCapital and Splash Financial. Darien Rowayton Bank also offers a medical residency refi loan in addition to its standard refinance loans for graduates with a broader range of degrees and good paying jobs.

There’s no question that medical residents are good credits, nearly as good as fully practicing doctors.

“Failure to complete [residency] is less than 1% after adjusting for program transfers, and once they do, the placement rate is almost 100%,” said Rich Rein, the chief financial officer and head of capital markets at LinkCapital.

Borrowers who fail to complete their residency, perhaps because they decide that they don’t care for their chosen specialty, are still highly employable in other areas, such as biotech research or medical technology. “The big risk comes down to timing — will they complete a program on schedule,” Rein said.

Yet funding residency loans can be tricky because these loans are negatively amortizing. The unpaid interest that accrues during residency is eventually recapitalized, adding to their debt load.

For many potential loan buyers, even banks, “there’s a mindset, they want a current-pay asset,” Rein said. The fact that residency loans offer higher returns than standard refinance loans, because they pay slightly higher interest rates, fails to sway some investors, he said.

The prepayment profiles of residency loans are also tricky. Prepayments on typical refinance loans are pretty high, as high as 15% to 20% a year in pools of securitized loans rated by the credit rating agency DBRS, because the borrowers tend to have a lot of disposable income that allows them to repay their loans ahead of schedule. The opposite is true of residency loans; borrowers are in a poor position to make extra payments before they complete residency, which may take six years in some cases. Yet once they are fully practicing, borrowers may have an incentive to refinance again, if they can get a slightly better rate based on their current income.

For this reason, LinkCapital’s residency loan features a fixed rate of interest that steps down to a predetermined level once borrowers complete their training. This results in a lower annual percentage rate over the life of the loan than on the loans the company offers fully practicing doctors, but it also takes away some of the incentive for a borrower to refinance.
LinkCapital has been lending since mid-2015, and to date all of its funding has come through whole-loan sales, though some of the buyers have subsequently bundled the loans into collateral for bonds.

Splash Financial, based in Cleveland, is an even newer entrant. It launched a residency refinance loan this summer that is funded through forward-flow agreements with banks. The monthly payment while borrowers are in residency is just $1 a month, as opposed to the $100 for borrowers who refinance with SoFi, LinkCapital or Darien Rowayton. But the unpaid interest is capitalized monthly rather than at the end of the residency.

Steve Muszynski, the company’s chief executive, said the low monthly payment is a selling point, at least for borrowers. “One dollar a month really helps when you are cash poor,” he said. “We explain to banks and utilize historical data on losses in our analysis; that $300 doesn’t even cover the interest, so what’s the difference between that and $1?”

While many medical school graduates go into some kind of loan forgiveness or repayment program while in residency — 47% of the class of 2017, according to the Association of American Medical Colleges — they may still have monthly payments of several hundred dollars.

Refinancing is “the difference between living in a nice apartment versus one that is not so desirable, between going out to dinner, traveling a bit,” Muszynski said. He said Splash has worked with medical residents who have been taking out high interest credit cards to pay for such expenses. “They’re swapping one type of debt for another,” he said. “This is a group of individuals that is incredibly intelligent, but has not had much financial training.”

SoFi’s entrance into the residency refi market has forced Splash to rethink some of the features of its product. Some of the shorter terms that SoFi offers allow it to advertise very low interest rates, even if a five- or seven-year loan might not make sense for many medical residents since it usually take them far longer than that to fully repay.

So Splash is mulling whether to expand the range of terms it offers, just to make its products more easily comparable to those offered by SoFi and others. Splash may also eliminate features that can be perceived as negative. An origination fee [unusual among refi lenders] is being removed Nov. 17.

The company may also change its capitalization policy. “Capitalization is a function of interest rates,” Muszynski said. “We do it monthly, and they do it at the end of the [deferral] period. [Our] all-in cost should still be lower, but it’s confusing to borrowers. We’re trying to eliminate any confusion and clearly present the strongest product in the market.”

Negative amortization may be a tough sell for some banks and other investors in whole loans, but Darien Rowayton has had no problem funding residency refinance loans in the securitization market. They represent 11.4% of the outstanding balance of the bank's most recent transaction, the $300 million Laurel Road 207-C, which launched this week.

Since February 2015, Darien Rowayton has originated some $309 million of medical residency loans with no defaults and no delinquencies over 60 days, according to DBRS’ presale report on the transaction.

In fact, DBRS thinks that the inclusion of medical residency loans may actually increase the appeal of such bonds for investors. That’s because the loans may help moderate prepayment speeds in these deals, which have been a concern for investors.

The large principal balances and higher loan rates on medical residency loans (compared with loans that are in full repayment) provide an additional benefit for securitization investors. Any interest income from the loans that is left over after paying interest to bondholders is set aside by the securitization trust and can be used to offset a future shortfall.