Income share agreements (ISAs) have been identified as a new potential source for financing higher education, making important investments in human capital improvements while limiting some of the debt burden placed on students. This article will explore why some believe that alternatives to traditional student loans are needed and will also examine the promising solutions ISAs could bring to students and the economy as well as explore their potential challenges.
The Need for New Options
Currently, total student loan debt in the U.S. outweighs all other types of debt except home mortgage loans. Outstanding student debt has tripled in the last 10 years, and increasing default rates are a widespread concern.2 Research from the Federal Reserve Bank of New York has suggested that growing student debt burdens may impede younger borrowers from moving into homeownership.3 High student loan debt levels increase a borrower's debt-to-income ratio and make it more difficult to qualify for a mortgage.
Some students do not complete school or do not obtain the income they had expected after graduating, yet are left with the costly debt of their investment in education. The federal government has taken steps to address this risk faced by many students by introducing income-based repayment plans. These plans cap monthly loan payments at 10 percent of current income over a period of 20 years, and over 10 years for government and nonprofit jobs. The remaining debt is forgiven, although it is treated as taxable income.4 Though this solution eases some of the burden for borrowers, income-based repayments shift the risk to the federal government, costing taxpayers billions of dollars in forgiven debt. Additionally, this solution provides little incentive for academic institutions to control the rising cost of tuition.5
The Concept: Income Share Agreements
ISAs are a financial product through which a student receives capital to cover higher education expenses in exchange for an agreement to pay a percentage of their future income for a set period of time. After the agreed-upon term concludes, the payments cease even if they did not fully cover the initial investment. Likewise, payments continue through the end of the agreed-upon term even if the total payments outweigh the original investment. ISAs, which are essentially equity investments in students rather than loans to students, shift the risk of labor market outcomes and future earning potential from students to investors. Investors typically invest in pools of students so as to diversify the risk of one particular student's success.
This concept involves investors assessing risk based on the major chosen and university attended, and determining pricing based on the projected future earnings of the student. For example, ISAs will ultimately cost the student less if the chosen degree is expected to yield higher future earnings or if the degree program has a lower cost. Alternatively, ISAs will require a higher percentage of income or set a longer payment period for students who choose relatively expensive degree programs or degrees that have lower expected future earnings, as seen in the degree comparison example below from Purdue University's Income Share Agreement Comparison Tool. The tool allows users to determine what their income share would be based on their degree program and expected graduation date and also compares the most common education financing options considered by students who are also investigating ISAs.6
|Major||Aero & Astro Engineering||History|
|Projected Starting Salary Upon Graduation||$60,000||$35,000|
(i.e. Annual Percent of Future Income)
|3.3 percent||4.74 percent|
|Term||92 months||112 months|
Note: Both estimates are based on an ISA of $11,000.
Advocates of ISAs stress that, unlike traditional student loans, this product may cause students to ponder their expected return on investment when choosing a school or a major since those decisions will directly impact the cost of financing their education. Additionally, if the market for ISAs were to grow, this type of data would hypothetically become more available to both investors and students and could ultimately lead to institutions controlling the cost of tuition by keeping prices in line with value or by pricing degrees differently depending on their expected return on investment.7
ISAs are not a new concept. The idea was originally credited to Milton Friedman in the 1950s.8 Though not widely used in the U.S., this concept is popular in countries in South America as well as Australia. Lumni,9 an organization that has funded thousands of ISAs in international markets, is now offering ISAs in the U.S.
Recently, Purdue University announced a new initiative in partnership with Vemo Education10 and 13th Avenue Funding11 and, in Fall 2016, will become the first American university to make ISAs available to students.12 In the case of Purdue, and potentially other mission-oriented investors, excess earnings from those who graduate and go on to earn a significant income will be placed back into the fund to compensate for the shortfall from students who fail to graduate, enter less lucrative fields, or have trouble obtaining employment after graduation, as well as to finance future agreements.
One common critique of ISAs is that students who pursue majors leading to lower-paying jobs, including jobs that yield high social return such as public service careers, are less likely to get ISAs that have more attractive terms than traditional financing.
With current federal subsidies for student loans, ISAs may be an attractive option only to those currently seeking private loans. ISAs could become a popular option at schools that do not offer federal loans, such as some community colleges13 and for-profit colleges,14 and short-term career "boot camp" programs that do not currently qualify for federal aid.15 However, it is unclear if financing students at these institutions would be of interest to investors involved in ISAs.
Lack of regulation surrounding ISAs in the U.S. has inhibited the growth of this market to date. Observers of ISAs say that legislation is needed to provide guidelines to investors interested in offering these innovative financial products and to provide safeguards to protect consumers.16
Considerations for Low- and Moderate-Income Consumers
Underwriting practices could hypothetically produce a situation in which affordable ISAs were not evenly available across the socioeconomic spectrum. For example, how will investors price ISA offerings in light of factors such as high school ratings and student performance as indicated by SAT scores? Though certain students may be deemed too risky by mainstream investors seeking strong financial returns, there may be an opportunity for mission-oriented impact investors to enter the ISA market to assist students from disadvantaged backgrounds.
ISAs could prove to be a useful tool for students from low- to moderate- income households who are debt averse or who receive federal grants or other tuition subsidies and only need to fill a small financing gap. Using an ISA to supplement other sources of capital could help students cover the full costs of tuition, books, and room and board by allowing them to tap into future earnings.17 ISAs may contribute to lower dropout rates, since more than one fourth of students who leave college in their first year report that financial concerns influenced their decisions.18 Additionally, credit scores are not at risk of being negatively affected if students find themselves earning less than expected after graduation. Since an ISA is an investment, not a loan, students have the opportunity to increase their net worth without having to first pay down the liability of large student loans. This ultimately could lead to improved household balance sheets and increased financial stability.
While ISAs bring innovation in higher education finance, further experience and research are needed to determine whether this product could bring relief to students and opportunity to those from low- and moderate-income households. As the market develops, regulation will need to strike a balance between encouraging more participation in ISAs from investors, while protecting consumers engaging in this new financial tool. Results of pilots such as the one being launched by Purdue University will be of interest to those considering the feasibility of ISAs as an alternative to traditional student loans.
Purdue University Income Share Agreement Comparison Tool, available at www.purdue.edu/backaboiler/comparison/index.html.
The views expressed here do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
For a detailed examination of trends in student debt and delinquencies, see Adam Looney and Constantine Yannelis, "A Crisis in Student Loans? How Changes in the Characteristics of Borrowers and in the Institutions They Attended Contributed to Rising Loan Defaults," Brookings Institution, Fall 2015, available at www.brookings.edu/about/projects/bpea/papers/2015/looney-yannelis-student-loan-defaults.
Not adjusting for inflation, outstanding student loan debt in 4Q2005 was $0.39 trillion and in Q4 2015 was $1.23 trillion, according to the Center for Microeconomic Data of the Federal Reserve Bank of New York, available at www.newyorkfed.org/microeconomics/hhdc.html.
Zachary Bleemer, Meta Brown, Donghoon Lee, and Wilbert van der Klaauw, "Debt, Jobs, or Housing? What's Keeping Millennials at Home?" Staff Report 700, Federal Reserve Bank of New York, September 2, 2015, available at www.newyorkfed.org/research/staff_reports/sr700.html.
Stacy Cowley, "Getting a Student Loan with Collateral from a Future Job," New York Times, April 8, 2016, available at www.nytimes.com/2016/04/09/business/dealbook/getting-a-student-loan-with-collateral-from-a-future-job.html?_r=0.
Robert Kelchen, "Who Would Use Income Share Agreements to Pay for College?" Brown Center Chalkboard, Brookings Institution, August 25, 2015, available at www.brookings.edu/blogs/brown-center-chalkboard/posts/2015/08/25-income-share-agreements-kelchen.
Beth Akers, "How Income Share Agreements Could Play a Role in Higher Ed Financing," Brookings Institution, October 16, 2014, available at www.brookings.edu/research/papers/2014/10/16-income-share-agreements-akers.
The Institute for College Access & Success, "At What Cost? How Community Colleges That Do Not Offer Federal Loans Put Students at Risk," July 15, 2014, available at http://ticas.org/sites/default/files/pub_files/At_What_Cost.pdf.
Judith Scott-Clayton, "The Hidden Majority of For-Profit Colleges," New York Times, February 24, 2012, available at http://economix.blogs.nytimes.com/2012/02/24/the-hidden-majority-of-for-profit-colleges/?_r=0.
Ainsley O'Connell, "Financing Options Are Finally Catching Up with Coding Bootcamps' Growth," Fast Company & Inc., July 16, 2015, available at www.fastcompany.com/3048320/most-creative-people/financing-options-are-finally-catching-up-with-coding-bootcamps-growth.
Shu-Yi Oei and Diane Ring, "Human Equity? Regulating the New Income Share Agreements," Vanderbilt Law Review, 68(3) (2015), pp. 681–760, available at www.vanderbiltlawreview.org/wp-content/uploads/sites/89/2015/05/Human-Equity-Regulating-the-New-Income-Share-Agreements.pdf.
"The Potential Market for Income Share Agreements Among Low-Income Undergraduates: An Issue Brief for Policymakers and Advocates," American Institute for Research, September 2015, available at www.air.org/sites/default/files/downloads/report/Income-Share-Agreements-ISAs-Potential-Among-Low-Income-Undergraduates-Sept-2015.pdf.