Investing in value, sharing risk: Financing higher education through Income Share Agreements

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Article Highlights

  • Students struggling with increasing tuition costs would benefit from a financing tool that is better aligned with their interests.

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  • Trad. private student loans force students to bear significant risk of financial ruin if their ed. investment does not pay off.

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  • ISAs would improve the efficiency of educational delivery, lowering costs for students.

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Executive Summary

Income Share Agreements (ISAs) are financial instruments for the private financing of higher education. With an ISA, an investor or other organization provides a student with financing for higher education in exchange for a percentage of the student’s future income for a defined period of time after the student finishes school. Unlike a loan, there is no principal balance to repay with an ISA: depending on the level of success after school, the student may ultimately pay more or less than the amount financed.

ISAs are better suited for student financing than traditional student loans. Investing in higher education is risky, meaning the outcome of investing in students is highly uncertain. Loans are not ideal for financing an individual’s education because they cap payments to the lender while forcing the student to bear too much risk. On the lender side, this means that the private student-loan lenders undersupply credit (even for students with good prospects) without some kind of government guaranty or subsidy. On the student side, traditional private student loans force students to bear significant risk of financial ruin if their educational investment does not pay off and they do not earn enough income to repay their debt with interest.

In capital markets, risky investments are typically funded with equity instruments where the investor shares in the profit (and the loss) of an investment. Borrowing from this payment structure (but without the ownership aspects of traditional equity instruments), an ISA has students pay more if they are successful in exchange for paying less if their educational investment does not pan out. This provides strong downside protections for students while making it easier for students of all backgrounds to obtain financing compared to the undersupply of credit that occurs with traditional private student loans.

In addition, because ISA investors earn a profit only when a student is successful, they offer students better terms for programs that are expected to be of high value and have strong incentives to support students both during school and after graduation. This process gives students strong signals about which programs and fields are most likely to help them be successful. It would also help stem tuition inflation and improve the efficiency of the higher education system by rewarding high-quality, low-cost programs.

In short, ISAs offer the following virtues:

  • They make financing available to students of all backgrounds for worthwhile educational programs without requiring a government guaranty or subsidy.
  • They offer students strong repayment protections similar to the income-based repayment option for federal student loans.
  • They improve the efficiency of the higher education system by channeling students to high-quality, low-cost programs.
  • They help students navigate to programs that will help them find a job and succeed in the workforce.
  • Because no taxpayer dollars are put at risk, ISAs open a space for innovative educational providers who are currently shut out of the federal financial aid process through accreditation and other regulatory barriers.
  • ISA investors have strong incentives to support the students they have funded during school—via advising, mentoring, and career counseling—as well as after graduation.

The federal student loan system was created decades ago as an attempt to address some of the failures with private student loans described above. Because federal loans are available with essentially no underwriting criteria, students of all backgrounds have access to the credit they need to go to school. And, more recently, programs such as income-based repayment provide students with strong protections against the downside risk of investing in higher education.

Nevertheless, federal student loans help undergraduate students only up to the Stafford loan limits, leaving many students with only private loans or Parent PLUS loans above those limits, both of which are highly problematic. In addition, because they are available to students with virtually no assessment of the students’ ability to repay, federal loans likely exacerbate problems with overborrowing, putting students and taxpayers at risk and contributing to tuition inflation.

Federal student loans have become an essential component of student access to higher education. Still, for many students, federal loans are inadequate for their financing needs, and simply raising federal loan limits risks exacerbating issues with overborrowing and tuition inflation. Therefore, students need access to additional financing tools they can effectively pair with federal student loans to meet their higher education financing needs. ISAs are not currently a full substitute for federal student aid programs, but they can help correct some of the existing system’s shortcomings and improve student outcomes. As ISAs take root and expand, policymakers will have opportunities to think more expansively about their role in higher education finance.

Therefore, policymakers should take the following steps to facilitate the growth of ISAs as a new financing option for students:

  1. Legal Clarity. There is significant legal uncertainty regarding the treatment of ISA contracts. Although some small firms are testing this market, this uncertainty has made it difficult to attract investors and has prevented the market from developing on a larger scale. Congress should take steps to provide legal clarity regarding the treatment of these contracts.
  2. Loan Limits. Instead of allowing students and parents to borrow up to an institution’s cost of attendance through federal PLUS loans, policymakers should put reasonable loan limits in place for federal student loans and implement reforms that allow ISAs and state-based Pay It Forward arrangements (which are essentially state-funded ISAs) to emerge. These reforms would give students a suite of robust financing options to take advantage of without the downsides of unlimited borrowing through the federal program.
  3. Interaction with Federal Student Loans. Congress should make several modifications to federal student loans to both simplify and improve the repayment process for students while eliminating barriers that would make it difficult for students to pair federal loans with other financing tools such as ISAs and Pay It Forward arrangements.
  4. Data. Policymakers should repeal the ban on student unit records and allow for the collection and dissemination of data on the labor market outcomes of graduates from different institutions and fields of study, without infringing on student privacy. Markets function much more effectively with good data, and right now there is a dearth of information available on the outcomes at different postsecondary programs.

 

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