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If you thought mortgage-underwriting standards were lax right before the housing crisis, wait until you take a closer look at student loans. Borrowing for a house at least requires an appraisal of the property and an assessment of the borrower’s future capacity to pay. Student loans require neither. Instead, students and families are encouraged to invest in any program at any price. There is a better way, but it’s time to look beyond traditional student loans.
Today, easy credit from federal loan programs provides little incentive for campuses to keep tuition low, and many students and parents gladly borrow to pay these increasing costs, only to run into financial trouble when the loans come due. Delinquency rates on student loans reached 12% in 2013, higher than the roughly 10% delinquency rate on mortgages at the height of the housing crisis in 2008-09.
On balance, college is a good investment, in terms of future earnings and even quality of life. But not every degree from every institution is worth it. More than 40% of those who start a degree do not finish within six years, and many graduates find themselves unable to get a job that pays enough to justify the investment. In 2012, nearly 45% of recent college graduates were working in jobs that did not even require a degree, according to Federal Reserve data.
The federal student-loan system is no help, since lenders do not consider the likely return on degree programs when making loans, leaving students with no information about the value of different options. The standard 10-year repayment plan demands the heftiest percentage of a graduate’s income in the years immediately after graduation, threatening young adults with financial ruin if their choices don’t lead to a steady income. Struggling borrowers can apply to have payments capped at 10% of their income, but by then it’s too late to change what they studied and what it cost.
All this is why the higher-education world should consider a creative student-loan alternative. In capital markets, risky investments often are funded with equity instruments under which the investor shares in the profit or the loss of the investment. This arrangement provides the necessary capital and spreads risk across both investors and entrepreneurs.
Enter income-share agreements ( ISAs ), which are essentially equity instruments for human capital. Investors finance a student’s college education in return for a percentage of their future income over a fixed period. ISAs are not loans and there is no outstanding balance. If students earn more than expected, they will pay more, but they also will pay less—or nothing—if their earnings do not materialize.
The growth of ISAs would create more educational opportunity and reduce risk for students pursuing higher education. ISAs make financing available to students regardless of background without a government guarantee or subsidy. They would also alert students to high-quality, low-cost programs, as investors will offer the most favorable terms for programs with a reasonable price tag that help graduates succeed in the workplace. This, over time, could curb tuition inflation, and lower the cost of college. But most significantly, ISAs protect students from the severe downside risk of traditional student loans.
Variations of this idea are picking up steam amid rising tuition costs and mounting student debt. On Wednesday, Sen. Marco Rubio (R., Fla.) and Rep. Tom Petri (R., Wis.) introduced the Investing in Student Success Act, which would set basic standards for ISA contracts. In Oregon, state legislators in 2013 introduced a “Pay it Forward” plan that would allow students to attend public colleges tuition-free in exchange for 3% of their income after graduation. During the past decade, a handful of organizations have sprouted up to unite investors and students. For-profit groups such as Lumni, Pave and Upstart, as well as nonprofits including 13th Avenue, currently finance students through ISAs.
Yet some policy obstacles are impeding a vibrant ISA market. A market needs investors, and investors need certainty about the legal and regulatory status of ISAs. Right now there is none. Congress should spell out the enforceability of these contracts by offering ISAs the same clear legal boundaries as any other contract. Secondly, ISAs need a regulatory home, perhaps an existing agency with experience overseeing student-loan products.
Congress should also impose limits on parent loans. Under the federal program known as PLUS loans, parents can borrow up to the cost of attendance with no lifetime limit. Replacing some parent PLUS debt with student ISAs would reduce overborrowing and the tuition inflation that comes from parents having easy access to unlimited funds.
Finally, the ISA market needs income data, which the federal government has a unique ability to provide. Unfortunately, the 2008 reauthorization of the Higher Education Act specifically banned the government from creating a federal, student-level database that could link postsecondary and wage information. If members of Congress want to foster a robust ISA market, the ban must go.
ISAs have the potential to revolutionize student loans without more taxpayer spending, and federal policy makers can help by creating a favorable regulatory environment. The Rubio-Petri bill is a start, but there is more to be done. Students are trapped in a broken system that dooms too many to financial hardship. Giving investors a stake in the economic success of students unleashes more educational opportunity for all.
Mr. Palacios is an assistant professor of finance at Vanderbilt University’s Owen Graduate School of Management, and co-founder of Lumni, a company that has used ISAs to finance higher-education students in Latin America and the U.S. Mr. Kelly is director of the Center on Higher Education Reform at the American Enterprise Institute.
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Stretching the Higher Education Dollar: How Innovation Can Improve Access, Equity, and Affordability
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