This is Not The World of Subprime Children

The student loan infrastructure in the United States is broken. There are dozens of plans available for borrowers—graduated, income-based, PAYE, RePAYE, to name a few—but there are still people who are struggling to pay their student loans. Outstanding student loan debt in the United States is at around $1.6 trillion—the second highest source of household debt in the country. And more than half of that was issued in the last decade. Income Share Agreements, or ISAs, are being used as an alternative to student loans and provide a promising solution to the crisis.

Student debt is a major problem, and lawmakers have many ideas about how to mitigate the crisis. Around 90 percent of student loans outstanding have been originated by the federal government, and recent reports have highlighted the continued failure of the Department of Education in overseeing the maintenance of government-issued loans. Indeed, the government can offer more attractive interest rates as a lender and can also offer more favorable repayment terms because they do not need to make a profit, unlike private lenders. However, the government has largely failed at creating strong repayment plans for student debt. The price of tuition is still rising, and outstanding debt continues to go up every year.

Income share agreements are based on a simple premise: someone—typically the school or a third-party investor—will advance you the money you need to pay for your education, and in exchange, you agree to pay a percentage of your future income. But critics have many questions about this model, perhaps most prominently the fact that it could open up more discriminatory practices in the higher education model. If students pay with a percentage of their future income, won’t schools start to only provide capital through ISAs to those who are likely to earn a lot of money? This is a rational argument, but upon further analysis, ISAs have clear protections to prevent that behavior.

A Brief History of Income Share Agreements

The concept of the income share agreement was initially developed by Milton Friedman in a 1955 paper on the government’s role in education. Friedman proposed that investors could buy a “share” in a person’s future earning prospects in exchange for giving them the money they needed to pursue their dream education. He wrote this in response to the fact that higher education loans are not securitized like a mortgage or car lease, in which you would lose the asset if you couldn’t pay. This meant that lenders had to assume too much risk and so had to offer high interest rates or make loans non-dischargeable in bankruptcy, so lenders would have a chance to earn their money back.

The first implementation of an income-share program was in the 1970s at Yale University. James Tobin, a Nobel Prize-winning economist, was tasked with designing a program that would make it easier for students to pay for college. Despite the ambitious plans, the program was poorly structured—students paid in a cohort and would continue to pay until the entire debt was repaid, but wealthier students could buy out of the cohort early if they paid a premium—and was shut down in 2001, even though the full fund had not been returned. Yale President Richard Levin once stated “We’re all glad it’s come to an end. It was an experiment that had good intentions but several design flaws.” The program was dubbed a failure, and nobody would experiment with income share agreements for years.

In 2016, Purdue University launched the “Back a Boiler” ISA fund, which would allow students to borrow money for their education in exchange for a percentage of their future income. Students would pay for a certain number of months a percentage of their income based on the major they have chosen. For instance, computer science majors would have more favorable terms than English majors. These terms were calculated based on the expected salary earnings of students so the college could earn a fair return on its investment. Thus far, the program has issued over 750 contracts, and in late 2018, Purdue raised a second fund to expand access to ISA-based funding for students. Other universities have since followed suit: Colorado Mountain College, the University of Utah, and dozens of other colleges have launched their own income share agreement programs.

Private Investors in Income Share Agreements

There is now also a small but growing private market for income share agreements. Coding bootcamps have used income share agreements as repayment programs for years. These bootcamps are education providers dedicated to providing an accelerated learning experience to those who want to break into a career in technology. Lambda School, for example, offers a nine-month computer science course and provides people with career support to help them get a well-paying job after graduation. In order to finance these programs, private capital is being used, and outside service providers like Leif are making investments into ISAs in hope of earning a return. ISAs still account for a small amount of the education finance market, but estimates by edly, an income share agreement marketplace, state that over 175 institutions will offer ISAs and originate around $500 million in agreements by the end of 2020.

One of the primary concerns about ISAs is that they will cause investors to prioritize returns over student outcomes. After all, why should a college invest in a student who has lower earning prospects when they can invest in a computer science student who will help them earn a quick return? Well, the answer is simple: income share agreements are not all about the money.

How Income Share Agreements Protect Against Discrimination

Income share agreements have grown in popularity, in part because they can increase access to education. ISAs are self-funding, which means that after investors provide initial capital and students start paying back their ISAs, they will have more money to invest in the end. Thus, ISA providers do not need to raise money on a frequent basis to maintain their funds and therefore do not need to offer attractive returns to compete with hedge funds or other high-return investment securities. 

Many ISAs are also targeted at people who would traditionally not be able to take out a loan. Colorado Mountain College, for example, offers ISAs to DACA recipients who are ineligible for many forms of federal student aid, so they can pursue their education at the institution. The University of Utah offers ISAs to students in their final year who want to complete their education but cannot access any more loans—dropout rates in Utah are very high for this reason.

Sure, there are more professional investors entering into the market. But income share agreements would not be able to grow past a certain point without the backing of professionals who have access to a significant amount of capital—philanthropic institutions can only fund so many ISAs. Professional capital is a necessary part of growth, and there are protections put in place to ensure they can earn a good return without having to offer poor repayment terms to students. For example, there is a payment cap put in place which means that students who earn a lot of money after graduation will only be able to pay a maximum amount before their ISA is forgiven. For low earners, there is a minimum income threshold to ensure they do not make payments when they are not in a position to do so, and deferment periods give investors an additional shot at earning a return without burdening students.

ISAs benefit from a cross-subsidization effect, which will help investors realize good returns while still offering favorable terms through ISAs. The high earners are required to pay back slightly more than they owed—payment caps are usually around 1.5 to 2.5 times the initial amount borrowed—which will subsidize the losses incurred by lower earners who have paid back nothing or very little toward their ISA. This means that investors can still offer ISAs to lower-earning students, and earn a good return.

Interest in Income Share Agreements from Policymakers

ISAs have also recently started to get more attention from policymakers. Although some Congressional Democrats have expressed concern about ISAs and discrimination—Sen. Elizabeth Warren in a recent letter described ISAs as “exploitative” and “simply a debt that must be repaid”—a bill has been proposed with bipartisan support to regulate ISAs. This bill, the ISA Student Protection Act, would not only clarify the position of income share agreements under the law, but would also make explicit amendments to consumer protection acts, such as the Equal Credit Opportunity Act, to prevent discrimination by lenders. It is also worth noting that major market players are already complying with proposed legislation without being required to do so—they understand the importance of regulation and maintaining a set of best practices.

Critics have highlighted concerns about how ISAs could reshape childhood. In a world with ISAs, many people believe that students will start to over-optimize their childhood to appear like an attractive investment and get good funding terms. Terms like minimum income thresholds and payment caps protect students from paying back unreasonable amounts of money and cap returns for investors. Therefore, even if an investor had an algorithm that could identify the next billionaires, they would only be able to realize a certain return. It would not be worth it—investors would get bad publicity, and students would likely not stand for a world where their education was determined by an algorithm. Income share agreements can expand coverage to people who would not traditionally pursue further education because they are either unable or unwilling to take out student loans—this sounds like the opposite of perpetuating discriminatory practices.

Indeed, there is a chance that investors may try to exploit the system–every system is exploited by someone. But the rise of comprehensive legislation, additional attention by regulators, and lenders who have developed their own set of best practices has helped protect the market and ensure students are evaluated fairly, based on their potential. 

Algorithms may be able to help pick out the best talent, but they will not exist to maximize returns–they will exist to identify the people who have a lot of potential and passion but cannot access traditional financing terms. ISAs are pioneering a new revolution in higher education where students are evaluated not based on their ability to pay back a debt, but on their potential. This is far from a world of subprime children.