ISAs: The Friedman Solution to the Student Loan Crisis

In 2019, 44.7 million student loan borrowers owed a sum of $1.56 trillion, an average of more than $34,000 per student. Of those nearly 45 million student borrowers, 5.1 million have defaulted, meaning they failed to pay back their obligated debts.

A Possible Solution 

Income Share Agreements (ISAs) can connect investors and lenders interested in diversifying their portfolio with budget-constrained students in a voluntary exchange that could dramatically reduce the risk of default for students.

In an ISA, students are provided a fixed amount of money by a company or investor.This new source of funding has the potential to increase students’ future earnings through a variety of mechanisms. In exchange, students agree to pay back a defined percentage of future income over a set time period. As a student's income increases, both the investor and student reap the benefit. The agreements can include additional features, including a buyout option (where the student can pay a fee to exit out of the agreement) and an income exemption (where students are exempted from paying the investor back if their income falls below a certain threshold).

This new source of funding has the potential to increase students’ future earnings through a variety of mechanisms that include work relief and improved career opportunities for students after graduation.

ISAs were first proposed by Nobel Prize-winning economist Milton Friedman in 1955 and are growing in their infant stage at universities and private companies across the world. 

Value Proposition

Students who receive funding are relieved from tuition, fees, and living expenses, enabling them to perform better in school with a reduced obligation to work during the academic year.  Gary Pike, a professor of higher education at Indiana University–Purdue University Indianapolis, reported that working more than 20 hours per week has a negative impact on students’ grades whether on- or off-campus. Jonathan M. Orszag, Peter R. Orszag, and Diane M. Whitmore found that working more than 20 hours a week off-campus contributes to a higher likelihood that students will drop out.

Under the bands of income share agreements, both lenders and students share heavy incentives to increase students’ earnings after graduation.

Due to rising college costs, the number of traditional-age undergraduates working between 20 and 34 hours per week was up to about 21 percent in 2007, along with 8 percent working at least 35 hours per week. This proportion has increased in the past decade as college costs have continued to rise. According to a Georgetown University study, half of college seniors were found to have completed internships, and graduates with paid internships receive starting annual salaries of $52,000. Those without internships started jobs after college at $37,000. Additionally, 63 percent of college graduates with a paid internship received job offers compared with 35 percent percent of graduates who had no internship. When Income Share Agreements free students from the burden of working more than 20 hours per week, their likelihood of becoming employed and their income upon finding a job will substantially increase.

Under the bands of income share agreements, both lenders and students share heavy incentives to increase students’ earnings after graduation. Lenders are financially rewarded by offering mentoring, advice, and even job opportunities to borrowers. Additionally, the risk is shifted from the student to the investor so that in the event that students do not earn high income after graduation, the student’s cost is minimized to only a percentage of their smaller income.

Examples in the Market

The Back a Boiler Income Share Agreement has grown to more than 850 contracts with students who have received funding totaling over $10 million. The terms for the Income Share Agreement vary by college major because of the variance in expected earnings. An Aeronautic Engineering Technology major graduating in December 2020 would pay back $10,000 with a 3.36 percent income share over 96 months, while an English education major graduating at the same time would be required to repay 4.96 percent of income over 116 months. Edly, another new entrant into the market for ISAs, is a marketplace that connects schools with accredited ISA investors.

Edly, another new entrant into the market for ISAs, is a marketplace that connects schools with accredited ISA investors. Edly offers access to shares of ISAs, and schools ranging from “for-profit coding boot camps to nonprofit universities can list shares of their students’ ISAs on the platform,” paying an undisclosed single-digit fee to Edly.

In 1989, the Australian government set up the Higher Education Contributions Scheme (HECS) where students were only charged a $1,800 fee for university, and the Commonwealth paid the balance. Students could also defer the payment by promising a share of their income once they reach a specified income threshold to the government in the form of taxes. Here, the Australian government is banking on the share of income offsetting the initial cost.

Drawbacks

One financing company, Pave, ran into problems in 2015 because of a low level of investor take-up. Pave had received over 10,000 applications for funding but was only able to provide for 70 students. They found that the lack of legal clarity made it difficult for investors to commit to funding. In addition, the ISA structure encourages students to be dishonest about their true income or even hide their occupational intentions, perhaps claiming to be pursuing computer engineering when they actually plan to work as an art historian. Another risk is that ISAs may encourage students to be riskier with their employment decisions than they otherwise might be since they stand to reap the reward of higher income (even despite higher payback) and minimized cost if they end up with a low-paying occupation.

There is also a risk to students with higher than expected earnings after graduation. These students might end up paying a much larger sum than they borrowed. This risk is especially pronounced for students with less-preferred majors who take on less friendly contractual terms that require them to repay a larger percentage of their income. Most ISAs partially cap this risk at 2.5 times the initial borrowed amount, however, the amount repaid at 2.5 times is significantly higher than most private student loans would require.

The Rundown

Incomes Share Agreements add another vehicle of voluntary exchange for students that eliminates their risk of default if they are unable to find a high-paying career after college. Furthermore, better alignment of incentives has the power to increase the size of the pie for students and lenders while presenting investors with an option for increasing portfolio diversification. With an excess of $1.5 trillion in student loan debt and five million students in default on their loans, we are reaching the breaking point for the viability of student loans as an option for college financing. ISAs are a substantial step toward enabling students to pursue higher education without taking on burdensome debt and risking default.