What’s the Alternative to a Mountain of College Debt?

Meet Sarah, a very bright student in her junior year in high school. She excels in math and science and thinks that an engineering career of some kind would be her cup of tea. She wants to go to a college or university where a strong academic program will give her the knowledge she needs.

Sarah’s family, however, is not wealthy. In fact, they’re in the bottom income quintile and have nothing saved for college. They have thought about letting Sarah start at a nearby community college, which would keep the cost down to a level they could afford. The drawback is that spending two years there would be an educational waste of time since the coursework would be like repeating high school for Sarah.

Another option would be to take out student loans so she can afford to go to a university known for its high-powered engineering program. The problem is that Sarah’s family has had a bad experience with borrowing, having lost a house in the last real estate crash. Her parents understand that Sarah will probably be successful enough to be able to make the payments on the loans, but the lurking uncertainty bothers them very much.

If only they had some wealthy family member who could finance that ideal college experience for Sarah, confident that she would pay him back after she graduates and finds employment. But they don’t.

But in a world full of people who have investable wealth, shouldn’t there be some who would willingly front Sarah the money for college as long as they’d get a fraction of her future earnings? That is, people who would see that the best college education for Sarah would also be a good investment for them if they could make a contract with her.

Most readers know that the concept of wealthy people investing in higher education for a good student who just can’t afford the right college is one that has been around for quite a few years. It’s usually called an Income Share Agreement (ISA). I first heard about the idea in a paper by Miguel Palacios published in 2002 by the Cato Institute.

Soon thereafter, a company named MyRichUncle tried to put the ISA concept (also called human capital contracts) into effect, but it failed financially in 2009.

No matter—many companies with good ideas fail. The ISA idea is a very good one, since it puts private capital into the college decision process, rather than easily obtained student loans that are ultimately the taxpayers’ responsibility. As Kevin James and Rooney Columbus explain in this American Enterprise Institute article, “This creative approach flips the traditional student loan model on its head: Because an ISA has no explicit principal balance or interest, the ISA provider only earns its money back if the student is successful. Compare this to traditional loans where students are on the hook no matter how things turn out and how burdensome loan payments may be.”

Getting government out of college finance is a worthy goal, but what if the government itself is part of the reason why the ISA concept has thus far floundered?

Several federal politicians think that is the case. Two in particular are from Indiana: Senator Todd Young and Representative Luke Messer. Senator Young introduced the Investing in Student Success Act in the Senate in February and Representative Messer introduced the same bill in the House in June, where it is called the Investing in Student Achievement Act.

The thinking behind the bills is that the current legal framework in the U.S. is not conducive to ISAs because of legal uncertainties. When potential investors have to worry about uncertainty, they are likely to hold back. Writing on Forbes, Preston Cooper observes that “private ISA funders who make the wrong call run the risk of being investigated or sued by overzealous regulators and state attorneys general.”

To remove legal obstacles to ISAs, the bills make a number of changes and clarifications so that investors won’t have to worry about possible legal pitfalls. They cover a number of eventualities.

With respect to the income tax, the bills provide that ISA funders would owe federal taxes on their earnings from an ISA in excess of the amount they originally provided to the student and that students would owe no taxes on the funds they receive.

Another big point is whether a student can get out of making ISA payments by declaring bankruptcy. The bills state that ISAs will not be dischargeable in bankruptcy, just like student loans. This makes perfect sense, since the objective is to help propel the growth of this alternative to debt. If ISA investors know that a student, no matter how good his or her chances of success appear to be, might be able to escape having to pay them back, fewer will be willing to accept the risk.

Furthermore, the legislation puts a cap on the percentage of income the student must repay at 20 percent. If, contrary to expectations, a student has low earnings, he or she will not have to pay more than 20 percent of those earnings to the ISA investors. That provision is probably included to make the bill more palatable to Democrats, and indeed Rep. Messer has attracted two Democratic co-sponsors. While I don’t care for any federal interference in the contract terms, this may be unavoidable.

A similar, “liberal” provision is that any time the student’s income falls below 150 percent of the federal poverty line, he or she will not need to make any ISA payments. So if Sarah had an ISA but for some reason her earnings fell to only about $22,500 (the poverty line for a single person this year being just over $15,000), she would not have to make an ISA payment.

Again, that meddling with the terms of the contract is an unfortunate but probably necessary feature for the bills to find backing among Democrats.

No doubt one reason why two members of Indiana’s congressional delegation are spearheading the fight to boost ISAs is that Purdue University in their state has begun a pilot program to provide students with this non-debt funding alternative. Using funds from the Purdue Research Foundation and some private investors, the “Back a Boiler” program is designed to assist students who need additional money for college but don’t want more debt. While this ISA program is not meant to replace federal student loans, if successful it will clear that path.

This Washington Examiner article about Senator Young’s bill explains the advantage of ISA financing with the case of a nursing student. “Purdue calculated her expected income after graduation. She was assigned a payment of 4.8 percent of her monthly income for nine years…. Her monthly payment will be around $200 – $300, whereas the monthly payment for her private loan would be $350 – $500.”

An important feature of the “Back a Boiler” program is that students who plan to pursue studies in fields with better paying jobs have lower repayment rates than those who plan on lower-paying careers. Commenting about the program on Forbes, Jon Hartley writes, “For instance, a computer science senior will pay 2.57% of post-grad pre-tax income over 7.3 years for $10,000 of tuition paid through an ISA, while a liberal arts senior will pay 4.52% of their post-grad pre-tax income over 9.7 years for the same amount.”

That’s the market at work. Its non-egalitarian calculations are rooted in economic reality about the relative risks of different majors. That’s as it should be.

The Purdue ISA program seems to be carefully thought out. The Martin Center will report on its future success (or perhaps failure). In any event, it is an approach that other schools should consider.

As for the ISA bills, they are stuck in committee. If and when they advance, we will also report on that. Congressional leaders ought to push them through to a vote because the ISA concept fits perfectly with their goal of decreasing Americans’ reliance on Washington.