What Students Don’t Like About Income-Share Agreements

Last Friday, the American Enterprise Institute released Student
and Parent Perspectives on Higher Education Financing: Findings From Focus
Groups on Income-Share Agreements. If you want to know the findings in the
report, click on the link, there’s an executive summary. However, because I
tried to keep the report free of my speculation and personal opinions, I want
to use this blog post to mention some things that have come up for me since
doing these focus groups.

Income-Share Agreements (ISAs) are contracts where a student
accepts a set amount of money to finance her education and in return promises
to pay a set percentage of her income for a set number of years. It was
proposed by Milton Friedman in the 1960’s, and since that time has had a few
moments that eventually petered out. We are in the latest moment, and I’m hopeful
that this time ISAs will become popular. But if they do, it will partially be
despite, not because of, “experts” like me.

From an economic perspective, ISAs are a nearly perfect way
for financing higher education. At the beginning, traditional college-aged
students have no credit, and thus securing a private loan is difficult.
Furthermore, because there is no collateral (i.e. no asset against which the
loan is secured, like a house and a down payment) if a student has trouble
finding a job out of college, he might have extreme difficulty making the
payment. That’s unfortunate because, on average, the increased earnings he will
receive as a result of the degree will more than cover the cost of the loan.
This type of risk, where the student will probably do well but might do poorly,
is better suited to an equity investment. Just like how start ups sell a
percentage of ownership in their company (as opposed to getting a loan) a
student sells a percentage of his future income.

Lessons learned

Upside Risk

Before these focus groups, I always assumed the biggest
barrier to getting students to choose an ISA was the icky feeling they might
get from entering a contract for a percentage of their income. That did come
up, in a way. Students expressed concern over companies profiting off of
student success, but a lot of that concern was neutralized if the ISA provider
were a nonprofit.*

But a big concern that caught me off guard was that students
might pay back “too much.” Students intuitively understood that ISAs offered a
type of insurance (if you make less, you pay back less), but many were worried
if they made a lot of money they would pay back more than they would have under
a loan. 

“Of course you would!” screams the economist who believes in
rational actors. The investors, after all, are taking a risk, so they should be
rewarded. And besides, if you’re making more money, you can afford to pay more
back.

But students talked about this upside risk, the risk of
paying back too much, a fair amount in the focus group. This wasn’t an
overwhelming concern—a lot of people liked ISAs and the insurance, but concerns
about upside risk took me by surprise.

Obligation aversion

A number of participants in the focus groups wanted an
option to prepay their ISAs. That’s basically an impossible request. But it
makes sense as a request. Many people prepay their student loans. If you can
prepay the loan, you should. You get out of the obligation faster
(psychological) and you pay less interest overall (financial).**

With an ISA, the whole point is that you never need to
worry, as your payments will always be affordable based on your income. But
that wasn’t enough. Participants wanted the ability to get out of the
obligation faster, because they didn’t like the idea of having an obligation
any longer than was absolutely necessary. They also put value on the flexibility to get out of the obligation
faster.

This showed up when it came to the length of the term. When
participants were asked whether they wanted a 10, 15, or 20 year term, they
clearly favored the 10 year term, even
when it was made clear to them that the percentage income they would need to
commit would be lower with a longer term. If we had given them the option of a
five-year term with an ever higher percentage of income, they probably would
have picked that one.

That’s too bad for ISAs. Ideally, an ISA would be a very
long term with a very low percentage. That takes the burden off of the student
in any given year, and assures a smoother return on average for the investor
(because income smooths over longer time periods). But there may be little
appetite for those longer terms among students.

What this means for
ISAs

A couple of focus groups aren’t nearly enough to make any
predictions or claims about the demand for ISAs in general. But the issues
raised in the focus groups tell us a couple of things to look out for.

First, some percentage of students really don’t like the
idea of paying back too much, and so ISAs might need to adjust for that (or not
market to them at all). So far, most ISAs come with a cap, something like
“you’ll never pay more than 2 times what you were given”. But that tends to
freak people out, as they jump to that 2x number and focus on it.

Instead, my colleague at New America Mark Godfrey has hit
upon a potential way to soothe students’ concerns. Instead of an overall
maximum cap, you can instead cap the student’s monthly payment. Here’s how it
works: when a student looks at a potential ISA she would sees it compared to a
loan with a 10 percent interest rate, which would be equal to, say a $300 a
month payment. Godfrey’s idea is that though the student may pay less or more
than $300, she will never pay more
than $350 a month. They would get to “keep” 100% of their earnings
over that cap.

This goes a long way towards easing students’ concerns about
getting stuck in a contract where they pay way too much back. The problem is
that to compensate for the lost upside, the investor would have to raise the
income rate on everyone, thus making the ISA more expensive for people earning
lower incomes. So the question moving forward is, how much do people value
making a lower payment if they make little money, or a lower payment if they
make more money? Nobody knows right now, and more research is needed.

The other question I’m left with is do people really want
ISAs, or do they want loan insurance? ISAs are complicated, you have to submit
documentation every year to figure out how much your monthly payment would be.
This is all in the name of protecting students against downside risk. But what
if what students really want is actual insurance?

For instance, even with ISAs, a number of participants asked
what happens if they have large medical expenses or other lumpy payments. ISAs
can deal with that through deferments, but it’s telling that guaranteeing a low
payment if income is low doesn’t fully cover the insurance aspect for some
students.

So, what if we compared a loan with insurance to an ISA?
Insurance would come in the form of an origination fee, down payment, or added
monthly fee. This insurance would allow for reduced interest or completely
interest-free deferment during periods of extremely low-income or high expenses
(like medical bills). My hunch is that a number of students that like ISAs would
defect, because all they really want is insurance. And those worried about
upside risk might defect as well. That’s because even though they will pay more
each month for the insurance, their loss is limited—they won’t end up paying
back far more than they would under a loan.

When ISA proponents talk about benefits, they always mention
the product as a form of insurance. Maybe actual insurance is really what
borrowers want. 

*A couple of parents brought up indentured servitude, but it
wasn’t a pervasive sentiment.

**There is a downside to making prepayments. If you put all
of your disposable income towards paying off one debt, you leave yourself at
risk of needing to take on more debt at a higher interest rate in the event of
an emergency. That’s why I categorize getting out of the obligation faster as a
psychological concern, rather than a financial one.