If the definition of insanity is doing the same thing over and over again and expecting a different result, then higher education financing is the epitome of insanity. Since 1980, average tuition prices, adjusted for inflation, have risen by 245%. All too often the response from policymakers is to call for more federal student aid and government-granted loans. In fact, the largest source of higher education loan financing already comes from the federal government, with around 90% of outstanding student loan debt owed to the U.S. Department of Education. This system has produced a misalignment of incentives whereby universities continue to collect federal student aid and students continue to rack up debt, even though many will not earn adequate wages after they graduate to pay off these loans, leaving taxpayers on the hook.
However, there is a market-based alternative for higher education financing that might help remove the cost burden from American taxpayers while also encouraging students to pursue careers that will enable them to earn enough money to repay their debt. The solution is to shift from relying on debt to finance higher education to financing education as an equity investment. The concept was first mentioned by Milton Friedman in the 1940s as a footnote in Income from Independent Professional Practice and further developed in 1955 with the publishing of The Role of Government in Education.
Friedman’s early work on the potential for private financing of higher education as an equity investment forms the basis of what we refer to today as income share agreements. ISAs are increasingly being adopted as a private mechanism to fund higher education, with a small number of ISA providers already operating in Latin America and the United States.
With an ISA, investors fund students’ higher education in exchange for a fixed share of their future income for a defined period of time after the student graduates. Both the share of income and period of repayment are determined by the perceived value of the college course of study in relation to potential future income. These metrics are visible to both investors and students. For example, an English major might agree to pay 0.4% of his or her income for every $1,000 received for a period of 10 years; that is, if the student borrows $10,000 and earns $40,000 upon graduation, he or she will pay 4% of that income for 10 years, or $1,600 a year. By contrast, a computer engineering student (with higher expected income) might pay 0.3% for a period of 7 years. Most ISA programs also have minimum income thresholds ranging from $20,000 to $30,000 and place a cap on total payments at around 1.5 to 2 times the amount initially borrowed.
As an alternative higher education financing option, ISAs have a number of key advantages over traditional forms of financing:
- They reduce risk for students by shifting the inherent risk of a student’s future income to the investor, acting as a form of insurance against future earnings shocks. What’s more, with the ability to defer payment, students are provided with protections against periods of low or no income (i.e., unemployment), meaning payments are always proportionate to a student’s ability to pay, and default caused by financial distress is eliminated.
- They improve equality of opportunity by providing financing based on prospective students’ potential to excel in their college programs. Students from low-income or disadvantaged backgrounds have equal access to ISA financing regardless of their families’ socio-economic status or the presence of a co-signer.
- They improve price signals and incentives. Making information available (such as the quality of institutions, quality of courses, lifetime earning potential, etc.) reveals the differences in value among career choices and provides information on the quality of educational institutions. In fact, articles on risk-based student financing argue that ISAs incentivize students to make better educational decisions. An ISA financing model would reward low-cost, high-performance institutions by making price information easily accessible in the form of income share rates and payment periods.
One possible barrier to the widespread use of ISAs is that their legal status is unclear. Traditional loans are subject to usury laws, special tax rules and legal caps on payment amounts. ISAs should be treated as equity in future income and not as traditional loans, but if existing laws determine that ISAs should be treated like traditional loans, then they may not be as effective in addressing our student debt problem. By clarifying the lawfulness of income share agreements, policymakers can instill legal certainty and alleviate the reluctance of investors and prospective students to enter the marketplace.
ISAs may not fix all of the problems with our current system of higher education financing, but they certainly should have a place in the diverse marketplace for higher education.