Finally, student financing that won’t produce one million defaults every year

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Nov 19, 2019

America’s student debt crisis can be measured any number of ways—dollar amount ($1.6 trillion), number of defaults per year (one million), or percentage of presidential candidates offering unrealistic solutions (100). Underlying the large numbers and soaring rhetoric is a sobering reality: while it’s true that we are paying too much for college, there is also something wrong with how we pay for it in the first place.

The federal student loan system was designed to increase opportunity for those pursuing higher education. And it has, for many. That said, it typically works best for those that least need it, and contains features that create unacceptable levels of risk for the individuals who most need the higher education system to facilitate socioeconomic mobility. Not only has the student loan system stunted their financial growth, but it has doled out its worst punishments on the students who struggle the most.

The most obviously problematic characteristic of student loans is that they consist of fixed, inflexible monthly payments that you owe regardless of whether you can afford them. The subtler problem lies in interest accruals that grow heavier the more you struggle with those fixed payments. The federal government partially addressed the fixed payment concern by creating the income-based repayment (IBR) model, where monthly payments track income. However, IBR loans still accrue interest—lower payments may not lead to default, but they still lead to additional interest accruals and increase your overall loan balance. For students who have the resources, including family wealth, to afford them, student loans work fine. For everyone else, the system devolves into a roach motel, where it’s easy to check in but can take decades to check out.

Income share agreements, or ISAs, could be a lower-risk alternative. ISAs allow students to pay zero tuition today in exchange for a fixed percentage of their income tomorrow, over a set period of time, and with no variable interest accruals. Students that make less, pay less. Students that make more, pay more. In an ISA, you only start paying when you get a job, and typically don’t owe anything unless your income exceeds a minimum threshold. These features protect students from defaulting in situations where their educational experience leads to poor workforce outcomes. In other words, if your education doesn’t pay off, you don’t pay either.

But there’s more than one aspect to ISAs that make them a compelling outcomes-based financing solution, when designed well. In addition to providing downside insurance, ISAs can incentivize the learners’ education providers to do their jobs better—tuition shortfalls and surpluses from students’ ISA payments are felt by the schools, giving them skin in the game. ISAs provide both a stick and a carrot, disincentivizing ineffective practices and rewarding good ones by making tuition revenue more immediately contingent on graduates’ incomes. In essence, where student loans only pay schools to enroll students, ISAs put financial pressure on institutions to create and deliver programs that prepare graduates for a financially stable career post-graduation.

The value of ISAs is perhaps best seen from the student perspective. A learner mulling over enrolling in a school or program that offers ISAs might consider the following:

  • If I can’t afford to pay upfront, and I can’t use student loans, I can still enroll.
  • If the school is up and running while offering ISAs, that means its graduates are, on aggregate, doing as well as expected in the workforce—the school accepts those that it can best help, and then helps them accordingly. The school can bring those effective practices to bear on my experience, too.
  • If things go poorly, I will pay less than I would under a loan, if I pay anything at all.
  • But I could end up paying more in total than I would under a loan if things go really well.

This last bullet is understandably a sticking point for many students. Having monthly payments track income makes ISAs affordable, but not necessarily cheaper. Some graduates may find that acceptable. They only pay more if they are earning more in the first place, so it’s a net win. Would they have achieved such strong outcomes had they gone to a different education provider, or had the school not had skin in the game? Others may view it differently, seeing the additional cost as punishing their success, or as paying “bonus tuition” for achieving more. 

But even if an ISA does cost more in total, it may be worth itISAs essentially have an embedded insurance policy. If there were an option for a mortgage under which borrowers would rarely, if ever, experience foreclosure, even while unemployed, that mortgage option would cost more. Many would willingly pay that extra cost. Others might prefer to stomach the risk of a traditional mortgage in order to pay less overall. Having choices would be helpful.

Our higher education financing system should be a propellant of socioeconomic mobility, not a financially crippling ball and chain. The current student loan system regressively punishes those who most need affordable solutions, leading millions into default, and improperly incentivizes institutions of higher learning. ISAs protect students from the worst effects of poor workforce outcomes, and incentivize schools to help students avoid poor outcomes in the first place. Instead of a roach motel, let’s opt for a system that has more features than bugs.

As a research fellow on the Christensen Institute's higher education team, Richard helps investigate novel business models in postsecondary education, professional development, and lifelong learning.