Been there, done that.

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Rubio's College-Cost Plan Deserves a Chance

Paula Dwyer writes editorials on economics, finance and politics for Bloomberg View. She was London bureau chief for Businessweek and Washington economics editor for the New York Times, and is a co-author of “Take on the Street: How to Fight for Your Financial Future.”
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Marco Rubio has taken a lot of heat for endorsing what some have derided as indentured servitude for college students.  

Intriguingly, the plan the Republican presidential candidate is backing is indentured servitude, though strictly voluntary, as he keeps pointing out. It's also one of the more promising solutions to the U.S. student-debt predicament.   

The new method, called income sharing, typically involves a "loan" (I'll explain the quotation marks later) from investors to students. Instead of paying the money back with interest, students contract to pay their investors a set percentage of income for a fixed number of years after graduation. 

The concept dates to 1955, when economist Milton Friedman concluded it made no sense to require new graduates to make fixed loan payments when earnings are so low. Instead, he suggested, why not make equity investments in human beings? Investors could finance college students by buying a share in their earnings prospects. Successful graduates, some of whom would pay back more than the initial investment, would compensate for the unsuccessful ones. 

As Friedman predicted, critics found the concept of investing in human assets creepy, and his plan failed to catch on in the U.S. But similar approaches were adopted in Australia and other countries. In 2013, Oregon became the first state to adopt a version of income share, and about half the states are now studying the idea.   

The plans are getting a second look by policy experts on the left and the right, other presidential candidates and some colleges. Purdue University, for example, last week signed a letter of intent with Vemo Education, a financial-services company, to explore the agreements. (The school's president, former Indiana Governor Mitch Daniels, was an early backer of the concept.) 

The key to making this approach work is in writing laws to protect students from taking too many risks, while making it clear that investors who lose money won't get bailed out by taxpayers. Rubio, who often talks about his struggle to pay off his college debt, has offered legislation in the Senate to give income-share contracts a legal foundation and to make sure borrowers understand what they are getting into. 

The agreements aren't really loans because there is no principal balance, interest rate or fixed payment. Students are basically selling equity in their earnings potential. Payments go up when income is high and down when income is low.    

An example would be a student agreeing to pay 10 percent of her salary over 10 years. If she borrowed $100,000 to study computer science, and after graduation nabbed a job paying $100,000 a year, over 10 years she would pay back $125,000 (assuming 5 percent annual salary increases) -- more than she borrowed.  Or if she is unemployed for whatever reason -- can't find work, say, or wants to obtain a graduate degree -- she pays nothing, and eventually could pay back less than she received. 

Don't confuse private income-share arrangements with the government's income-based repayment program. In the latest version, new borrowers can repay federal loans by pledging 10 percent of their discretionary income for 20 years, after which the balance is forgiven. As of mid-2015, about 2.8 million borrowers with balances of $157 billion had opted for some form of this plan. 

But even under income-based repayment, undergrads pay 4.29 percent interest and graduate students pay up to 6.84 percent. For the financially needy, interest can be deferred, but it gets tacked onto the principal and eventually must be paid. Nearly all students will still pay back more than they borrowed because interest piles up. Monthly payments can be deferred for economic hardship, but only for three years. After 20 years, any forgiven balance is subject to federal income tax. Until it's paid off or forgiven, college debt appears on an individual's credit report.   

What's more, student loans can't be discharged in bankruptcy, leaving default the only recourse for those unable to make payments. At that point, taxpayers are on the hook. 

Income-share agreements have none of these drawbacks. They could even pressure colleges to think twice about raising tuition and other expenses, which are skyrocketing because of easy credit, a recent Federal Reserve Bank of New York study found. Investors are more likely to offer generous repayment terms to students who choose fields in great demand, and who select colleges with a high rate of return on their degrees.

Over time, these incentives could produce a college market geared to income-share students looking to maximize their labor-market returns. As it stands now, colleges have little incentive to cut costs so long as students can borrow to their hearts' content.  

The college-debt problem, in some respects, is worse than we thought, recent data show. Outstanding balances now exceed $1.2 trillion, four times the amount of 12 years ago. One in six borrowers is delinquent or in default. Low-income borrowers, especially those attending historically black institutions, two-year community colleges and for-profit universities, hold much of the outstanding debt -- and are behind 70 percent of the defaults. 

This is the group that might benefit most from income-share, perhaps in combination with federal loans.    

The old way of liberally doling out loans predicated on a full-time, four-year academic environment doesn't work for everyone. As long as student loans are widely available, colleges will have little incentive to cut costs -- and higher education could be out of reach for millions. 

Income-share agreements, if written carefully to balance consumer safeguards and investor inducements, might begin to change that.   

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Paula Dwyer at pdwyer11@bloomberg.net

To contact the editor responsible for this story:
Katy Roberts at kroberts29@bloomberg.net