To borrow or not to borrow?

Photographer: Mike Mergen/Bloomberg

An Alternative to Student Loans, But Not a Great One

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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Some days, it seems as if you can't swing a cat in Washington without sending it wailing through a panel on student loans. Articles are written, bemoaning the burden that lashes graduates to a debt mountain, keeping them from taking amazing nonprofit jobs or buying a home. And everyone has a proposed fix, usually involving the federal government spending even more money on college students.

Here's one fix that doesn't require the government to open up the faucet of tax dollars: income share agreements. That's like taking an equity stake in a student. Funders advance college tuition against a certain percentage of future income, payable over a set number of years. I attended, yes, a working group meeting on the topic yesterday, and while the meeting itself was off the record, I came away with a lot of thoughts to share.

I went into the working group pretty skeptical. The notion has been around for a long time -- I first heard it at a business school startup competition sometime around 2000. It has failed at least one startup, and it may never take off in a huge way. There are definitely good use cases for this product -- but those probably do not include the majority of college students in the United States. Making income share agreements available to even a minority of students is daunting.

The first major issue is simply asymmetric information: College students know more about their work ethic, academic ability and career plans than you do. As long as they have a choice between taking on debt with a fixed balance, and debt that requires them to repay some substantial portion of their future income, you're likely to see people with high expected future incomes looking to finance their education through debt, while those with lower income prospects want to take on the equity finance. In order to compensate for this, the price of the equity finance -- the percentage of income that they will have to repay -- will rise, until this is an attractive financing model only for the worst income prospects, who will, while earning little money, have to repay a very high percentage of their income over a number of years.

Or at least, that's how it works in a frictionless economic model. In the real world, there are complications. Even people who intend to be high earners may place a very high value on the insurance that an equity-finance model offers, for example. Or the financiers can price discriminate, charging engineers a lower percentage than English majors. You could imagine some interesting side effects, like engineering programs charging more to capture some of the benefits of this easier finance. Even so, you could eventually reach equilibrium where some percentage of the population and an adequate number of investors were interested in this form of finance.

However, that is only the first problem. There's also moral hazard after I take out my loan. Knowing that I have to give the lender 5 to 10 percent of my income no matter what, do I choose a lower-paid job that offers me, say, more vacation time?

And then there are the problems outside of borrower and lender. Take regulation. Income share agreements look enough like student loans that they might fall under those rules -- with perverse effects. For example, state usury laws might end up capping loan payments for the best-off graduates, forcing financing companies to jack up rates on people who make less money. And should these obligations be discharged in bankruptcy? At the expense of other creditors, or last? These issues will probably need to be ironed out if these products are to become widespread.

Another question is whether servicing costs end up being particularly high. Figuring out the pricing may end up being more complicated than it is for mortgage lenders, which just turn to FICO scores and mechanical debt ratios. And complicated underwriting is expensive. Collections could be as well. Though in theory, an income share should be less susceptible to default than a traditional student loan, especially if it stipulates an income threshold below which no payments are due.

Finally, there's the problem of getting a new finance product off the ground. To raise capital for this sort of enterprise, you need to be able to show potential backers what their cash flows might look like. But since the product has only ever been tried on a small scale, no one really has that kind of data. And we wouldn't for a while: At first the market may suffer from more, or less, adverse selection and moral hazard than it would as a mature financial market. So it's hard to get the data so you can get the money so you can make the investments so you can get the data.

These problems are not necessarily fatal. Lumni has successfully made thousands of these investments, and is offering a decent return to its investors. But Lumni operates mostly outside the U.S., where other educational finance may not be available. Inside the U.S., it will be competing with the federal government, which offers heavy subsidies and payment plans on a sliding income scale. It's hard to see how an income share agreement, either non-profit or for-profit, is going to be able to compete.

I do see potential in two niche markets: religious students and religious schools. For them, the virtues of income share agreements could outweigh the vices.

Dave Ramsey, the evangelical personal finance guru, discourages people from taking on debt, even "good debt" like student loans. When he tries to talk his listeners through alternative methods, there's often a moment where you think: "Yeah, that's not really going to work for most traditional college students whose parents don't happen to live in a city with a good state school." For Ramsey adherents, equity finance, which minimizes the catastrophic risks of high debt, could be attractive. Students who follow the rules of Islamic finance could also benefit from a more equity-like means of paying for college.

Religious schools might benefit in another way. Think of Gordon College, a Christian school in Massachusetts that was at risk of losing its accreditation because the college opposes "homosexual practice." There's growing worry among conservative religious people that these schools will have to choose between their principles and their access to federal student loans, which are contingent on accreditation. The income share approach might well let these schools survive without student loan money.

There may be other limited uses for income share agreements, maybe as a supplement when student loans aren't quite enough. But in America, at least, income share agreements seem destined to be a niche product for students who would otherwise struggle. They won't substantially cut student loan debt. Or reduce the number of angst-ridden panels on the topic.

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

To contact the author on this story:
Megan McArdle at mmcardle3@bloomberg.net

To contact the editor on this story:
Philip Gray at philipgray@bloomberg.net