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.