Approximately 43 million people in the United States carry student loan debt and the total outstanding balance on U.S. student loans stands at $1.2 trillion. This level of debt is unsustainable, and new ways to fund higher education need to be considered. Income share agreements (ISAs) are an option that – if allowed to grow – could help many young Americans handle the cost of higher education.
First proposed by Milton Friedman in 1955, the premise of ISAs is simple: borrowers repay their loans by reimbursing investors set portions of their income over specified periods of time. If you earn more, you pay more. If you have no income, you pay nothing. The model differs from traditional loans because it shifts more risk to lenders. Investors accommodate the risk of ISAs by pooling applicants and adjusting pay periods and percentages of income.
Though their widespread use is untested, ISAs have received increased attention over the past several years. Oregon introduced the Pay It Forward program in 2013, Senator Marco Rubio (R-FL) and Representative Tom Petri (R-WI) submitted a legal outline for private ISAs in 2014, and several colleges have introduced ISA programs for their students to pay for school.
Purdue University’s innovative Back a Boiler – ISA Fund, set to launch this coming school year, is a prime example. Purdue University computer science majors with ISAs will pay smaller portions of their income over shorter periods of time than philosophy students due to the disparity in their average post-college incomes. Shares of income collected will be small, between three percent and five percent. Purdue has also set limits on the maximum amount of total income that can be collected, at 2.5 times the initial amount loaned.
Pooling applicants to mitigate risk is a central concept of ISAs. For example, if one applicant does not make enough money over the next ten years to cover the cost of the initial loan, another student from the pool with a higher salary will be able to offset the shortcomings of the first student’s income. If the entire pool underperforms, the lending source can raise rates or lengthen the repayment period for future agreements. Gathering data is essential to this process, and 21st century technology makes doing so possible.
ISAs’ most prominent flaw is adverse selection. Students expecting to earn high incomes would avoid ISAs, whereas students expecting to earn lower incomes might gravitate towards ISAs. This would cause the expected returns for investors to be lower. Students expecting high incomes would be even more likely to choose traditional loans over ISAs because the government makes federal student loans at a loss, and on more favorable terms, than private ISA lenders could provide.
Some have called ISAs “indentured servitude.” But the “indentured servitude” metaphor pretends that traditional student loans are innocuous. In reality, students cannot escape most traditional loans even if they have no jobs or do not graduate, whereas students graduating with ISAs have more flexibility. ISAs’ biggest draw is that they will not ruin students’ lives by dragging them down into debt spirals.
ISAs bring to mind a different question for some self-assured college students: What happens when you create the next Facebook? Would you needlessly give away your hard earned income? For example, imagine Mark Zuckerberg went to Purdue, needed financial aid, and took out an ISA.
For starters, Zuckerberg would be better off opting for an ISA rather than a student loan because he carries little risk of defaulting on the ISA, even though he dropped out of school to start his own business. Indeed, student loans hit college dropouts harder than any other segment of borrowers.
Purdue University’s rule that ISAs can only collect 2.5 times the initial amount loaned to students is critical to this example. Because Facebook’s popularity skyrocketed in the first couple years, Zuckerberg’s income would likely have been much larger than a typical student’s.
With the ISA collecting between 3 percent and 5 percent of his income, it is likely that Zuckerberg would have returned the maximum amount, at 2.5 times the initial sum invested, in the first two years of running Facebook. In this example, Zuckerberg would be free of his ISA within a year or two, and the extra revenue made from his ISA would be recycled back into the system to be made available for future students.
This anecdote has two important takeaways. First, ISAs can and should be subject to rules, such as capping total payments to colleges at 2.5 times the principal. Second, ISAs will mitigate risk for students who decide to pursue bold and innovative ideas without the burden of a fixed-sum debt obligation.
Government action and legal progress will determine the future for ISAs. The government should overhaul the current income-based repayment process and spearhead ISAs’ gradual implementation at a federal level. Another option is for the government to establish legal frameworks that encourage the private sector to lead the charge. In the absence of both of these developments, colleges themselves will develop ISA programs.
Income share agreements are not an instant panacea for America’s damaged higher education financing system. But, given time and attention, they could become a viable and common option for many students.
Sammy Kunitz-Levy is an E21 contributor.
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