Student loans are a big issue in the upcoming presidential election, with some Americans delaying big financial decisions because of the $1.3 trillion they owe.
Candidates on both sides of the aisle have outlined plans to deal with student loans, with both Marco Rubio, the Republican senator from Florida, and Chris Christie, the Republican governor of New Jersey, supporting the idea of investor-based programs. In short, this would mean students finance their education with equity instead of debt and repay investors, instead of lenders, based on how much they earn.
The idea isn’t new: startups have tried (and failed) to sell stock in people before, and Congress has taken up the issue through a Rubio proposal that hasn’t gone anywhere. But young voters should understand what it all means.
At the moment, students are limited to using debt to finance their educations if they can’t pay tuition with cash, grants and scholarships. They sign contracts with lenders who give them money for school, and are then required to pay it back, with interest, over long periods of time. The Obama administration has made it easier for borrowers to limit the amount they have to pay each month, based on their income. But not everyone is eligible for these relief programs, and it’s nearly impossible to get rid of student loans, even in bankruptcy.
The alternative equity-based idea is often referred to as an income share agreement, or ISA. In this setup, students would apply to finance their education using a pool of investor money. Investors might have selection criteria like students’ majors, schools chosen or prior academic performance. In exchange for money, students would agree to split future earnings with the investors for a set period of time, after hitting a certain minimum income.
The key difference between the two types of college funding is that with income share agreements, investors are taking a risk: they have no sure way of knowing whether students will graduate, or what they will earn once they do. If graduates earn very little, they may not get repaid at all. If graduates earn a lot, they could make a killing. (It’s also not entirely clear how regulations regarding discrimination in loan underwriting would apply to equity-based education financing.)
However, income share agreements haven’t been successful so far. One reason is that the terms are unduly burdensome.
For instance, under Rubio’s proposed law, anyone earning more than $10,000 a year could give up 15% of income during 30 years of work after graduating. Any lapsed time would be added back onto the agreement, so there would be no incentive against working. The required payments could not be discharged in bankruptcy court. Perhaps unsurprisingly, the bill has gone nowhere.
There are few precedents for functional income-share agreements.
Australia and the U.K. have allowed students to make payments based on their income for years, but financing in these countries still takes the form of a loan, meaning students can pay off their obligations early. Oregon has considered a program called “Pay it Forward,” under which students would contribute 3% of their annual salaries for 24 years. The bill is stuck in the legislature.
At least three startups—Upstart, Lumni and Pave—have experimented with private-sector ISAs in recent years. Legal and regulatory uncertainty kept big investors away, though. All three companies shelved their programs in the U.S.
Even if a reasonable proposal made its way into practice, there are questions about who, if anyone, would benefit from income-share agreements.
Those who pursue degrees that are highly profitable—bankers, dentists, doctors, lawyers, etc.—would probably be inclined to stick with debt because it can be repaid early and has no set relationship to income. Those who pursue degrees on the lower end of the expected earnings scale might find equity financing attractive, but investors might not find them attractive as candidates for financing.
This distortion, known as adverse selection, contributed to the failure of Yale’s 1970s experiment with pooled, income-based loan repayment. The highest earners were able to pay off their debt soon after graduating. Others defaulted, leaving those in the middle to shoulder the obligation.
There are also legal and ethical questions about this type of financing arrangement. Does pledging a portion of income to investors represent private taxation, which is illegal in the U.S.? Or worse: does it represent a form of indentured servitude? Even Milton Friedman, who first proposed equity financing for education in 1955, acknowledged echoes of “partial slavery.”
As it stands, there’s little chance a proposal like Rubio’s will become law. Democrats have toyed with the idea of income-share agreements in the past, but none of the party’s presidential candidates are proposing such a solution. The frontrunner, Hillary Clinton, would simply make college free for some future students and make existing debt cheaper for others. It’s far from certain that her ideas will have widespread support from Republican legislators.
David Floyd is an Atlanta native, Kenyon alum and NYC resident. His work has also appeared in Investopedia.