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Income Share Agreements: A Private Market for Debt-Free College

By Kenneth Megan, Shai Akabas,

Wednesday, September 2, 2015

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With higher education tuition and fees rising faster than inflation and total student debt standing at around $1.2 trillion, a new private financing mechanism is emerging as a debt-free alternative to traditional private education loans.

Income Share Agreements (ISAs) allow students to sell “shares” of their future earnings. An investor or institution—which can be for-profit or not-for-profit—provides upfront funding for a student’s higher education in exchange for a predetermined percentage of their future earnings over a set period of time. Unlike student loans, ISAs do not have a principal balance or interest rate, and a student’s monthly payments ultimately depend on their financial success after school.

Purdue University plans to begin offering ISAs in the spring of 2016. Calling its program Bet on a Boiler, the university is currently in the process of searching for a partner firm to establish and manage the ISA contracts.

Benefits of ISAs

ISAs can provide an alternative funding source for students who would otherwise borrow to pay for school. As we outlined in a previous blog post, 41 percent of student debt holders postponed contributions to retirement plans in 2013, and 29 percent delayed purchasing a home.

Private loans in particular tend to carry higher interest rates than their federal counterparts. Though they comprise a relatively small portion of the student loan market, private loans tend to lack the generous modification options that federal borrowers enjoy, such as income-based repayment and financial hardship deferment. Borrowers who have trouble making payments on private loans often have few options to avoid default.1

In contrast, ISA contracts are by definition income-based, which could make them an attractive alternative to loans, especially private ones. As recipients are required to pay a percentage of their future earnings—not a principal balance plus interest—their monthly payments are more likely to be affordable. The income-based nature of ISAs, however, also means that individuals who earn more than expected upon finishing school would pay more under an ISA contract than under a traditional student loan.

ISAs can be profitable to private entities. Lumni, a for-profit firm that offers ISAs throughout South America, has inked contracts with over 7,000 students since 2002 and realizes a 10-15 percent rate of return. Investors may be able to offer more attractive terms to students who attend high-quality and/or low-cost institutions—or to those who pursue majors that have high earnings potential. This signaling can be helpful to students, allowing them to identify fields of study that may be more lucrative, as well as the schools that provide the best value for their investment.

Potential Concerns

Despite these benefits, ISAs carry several potential concerns. For one, the current regulatory system is designed specifically for student loans, meaning that no regulations are in place to guide the unique characteristics of ISAs. For example, current regulations protect borrowers from predatory lenders by setting interest rate caps. This does not work for ISAs, which are based on a percentage of income and carry no interest rate. Similarly, while student loans are extremely difficult to discharge under current bankruptcy law, ISAs operate in a legal gray area, as the statute was not written with this type of product in mind.

To remedy the current absence of regulation, researchers at the American Enterprise Institute have proposed establishing minimum standards to protect students from unfair contracts. These standards could include limits on the percentage of income that students are obligated to forego, as well as a cap on the number of years for which students are required to commit to payments. The researchers also contend that, like student loans, ISAs should not be dischargeable in bankruptcy, as their income-based payments are designed to be affordable at any income level.

Another concern is that investors might not offer contracts to (or would be less willing to serve) students who pursue careers with lower expected earnings—such as social work or teaching—or those with a lower probability of graduating, such as first-generation students. This illuminates the importance of ensuring that other financing structures—like grants and loans—remain in place, and that regulations are promulgated so that ISAs do not strictly help individuals whose demographic characteristics indicate a higher probability of success. Ultimately, ISAs may not be a solution for every student, as investors would likely be most attracted to individuals pursuing certain fields of study – namely, private-sector careers with higher earning potential.

Current Proposals

Several lawmakers and university stakeholders are currently working to foster a more robust market for ISAs. Last month, Reps. Todd Young (R-IN) and Jared Polis (D-CO) proposed the Investing in Student Success Act, a bipartisan bill meant to establish a regulatory framework with clear parameters to guide ISA contracts. Specifically, the legislation would stipulate that individuals earning less than $18,000 per year would not be required to make payments on their ISA. The act would also cap the maximum payment period at 360 months, limit payments as a percentage of income, and clear up legal uncertainties by mandating that ISAs cannot be discharged in bankruptcy.

Purdue University President and former Indiana Governor Mitch Daniels is a vocal champion of ISAs, and Bet on a Boiler is the first of its kind in the country. Under the plan, students earning less than $18,000 would not be required to make payments, and payments would be limited to 15 percent of income for 15-year contracts, or 7.5 percent of income for 30-year contracts.

As tuition prices climb and student debt balloons, income share agreements have the potential to lower risks facing some student borrowers by offering fixed payments and avoiding heavy debt burdens. Though by no means a silver bullet for higher education financing, policymakers and institutions of higher education should continue to explore the potential for ISAs to promote college affordability and rein in the growing student loan burden facing Americans who are seeking higher education.

1 Private loans comprise around 8 percent of annual student lending, or $8 billion in 2014. According to a report by the Consumer Financial Protection Bureau, a majority of private-sector loans are taken out for enrollment in private institutions, which tend to have higher tuition prices than public schools. Private loans may be the only near-term financing option for students who miss the deadline to file the Free Application for Federal Student Aid (FAFSA), which is a requirement for federal borrowers.