Key Points
- In an Income Share Agreement (ISA), a promising new option to help students finance their education, a student receives private financing in exchange for agreeing to pay a percentage of his or her income for a set period of time after school. Therefore, unlike a loan, a student’s payments under an ISA will adjust with his or her income over time.
- Although a beneficial development for students, ISAs raise new questions about consumer protection. In particular, policymakers should not apply traditional consumer protections—specifically interest rate disclosures and caps on the interest rates lenders can charge—directly to ISAs because attempting to do so would likely harm the very students policymakers are trying to protect.
- Policymakers should create minimum standards to protect against unfair or unaffordable ISA contracts and create a clear disclosure framework that makes it simple for students to compare ISAs to each other and to traditional loans.
Executive Summary
A promising new option has recently emerged to help students finance their education: Income Share Agreements (ISAs). With this option, a student receives private financing in exchange for agreeing to pay a percentage of his or her income for a set period of time after school. With traditional loans, a student can easily find himself or herself burdened with unmanageable payments after graduation and, in some cases, a spiraling loan balance that he or she may never be able to repay. In contrast, ISA payments adjust with the student’s income over the life of the contract.
But while ISAs appear to be a beneficial development for students, they raise new questions about consumer protection. In particular, applying existing consumer protection laws used for loans—specifically, interest rate disclosures and caps on the interest rates lenders can charge—directly to ISAs without modification would likely hurt the very students policymakers are trying to protect, for two reasons. First, ISAs are not loans; they don’t have a principal balance or interest rate. From a practical standpoint, therefore, it’s not clear how traditional consumer protection tools would even operate in the context of ISAs.
Second, whereas each student pays the same interest rate with a loan—creating a potential burden for low-income borrowers—an ISA adjusts a student’s payments based on his or her circumstances. Thus, students who earn less pay less, while students who do better pay more because they can afford to do so. Because of this structure, however, applying a usury limit would have the effect of limiting payments from successful students, forcing ISA providers to charge all other students more. To use an analogy, if a government caps the amount of tax revenue it will collect from high-income taxpayers, it must raise taxes for low- and middle-income taxpayers to take in the same amount of revenue.
Proper consumer protections are still essential for ISAs. But existing protections should be adapted to fit the ISA structure in order to make them effective. In that vein, policymakers should create a minimum standard to protect against unfair contracts, where the ISA provider is likely to earn a significant profit even if the student does poorly after school. And because the intent of ISAs is to ensure that payments are always affordable, policymakers should set parameters to prevent ISA contracts that would violate a minimum standard of affordability.
Policymakers should be cautious, however, not to impose minimum standards so strict that they inadvertently foreclose market developments that might be beneficial to students. Instead of trying to regulate the ideal contract, policymakers should arm students with tools that allow them to compare their options effectively. To that end, all ISAs should carry a disclosure table that compares what a borrower would pay monthly under the ISA at various levels of income to a loan for the same amount of money and time period. Minimum standards combined with clear disclosure tools would help protect students from unfair or unaffordable ISAs while still enabling them to benefit from this promising new higher education financing option.
Introduction
Students thinking about taking out loans to pay for college face a dilemma. The cost of taking on loans will likely pay off in the long run, but some students may not be able to afford their initial monthly payment after school. Additionally, students who drop out of their program or for whom postgraduation earnings are far less than originally anticipated may face a scenario where they are saddled with debt they may never be able to repay.
Federal loans offer income-based repayment (IBR) as a tool to protect borrowers against this financial risk. Under IBR, borrowers can set their monthly payments at an affordable percentage of their income and have any balance remaining after 20 years forgiven. For a variety of reasons, however, many students choose to take out private student loans, either as a supplement or an alternative to federal loans. In 2013, the Consumer Financial Protection Bureau estimated that there was $165 billion in outstanding private student loans, and The College Board estimates that new private loans totaling $6.2 billion were made in the 2012–13 school year.[1]
But private student loans offer little in the way of protections should a student’s investment not pan out: the graduate is still on the hook whether or not his or her education has translated into a job providing enough income to afford the monthly payments. Recently, however, an alternative private option has emerged—called an Income Share Agreement (ISA)—that offers protections similar to the IBR option for federal student loans. With an ISA, instead of having a fixed amount to repay (as with a traditional loan), a student obtains private financing in exchange for agreeing to make payments linked to a percentage of his or her income for a set period after school.[2]
Because ISAs help relieve students of the financial risks of investing in education, they appear to be a promising development in higher education finance. They also raise new questions, however, about how policymakers should think about protecting consumers wishing to take advantage of this new option. Specifically, two protections traditionally applied in a loan context—caps on the interest rates lenders can charge consumers, and interest rate disclosures—should not be directly applied to ISAs, because ISAs differ in fundamental ways from loans. As a result, imposing these requirements without modifications could actually harm the very students policymakers are trying to protect.
This paper discusses in detail why these particular consumer protections don’t fit within the context of ISAs. Yet consumer protections are an important aspect of any financial product. We therefore propose alternative solutions that would offer similar protections to students, but without any of the distortions these traditional regulatory mechanisms would create. Said differently, we are attempting to mirror the intent of existing consumer protection laws while adapting their specific requirements to fit with how ISAs function.
Notes
1. Rohit Chopra, “Student Debt Swells, Federal Loans Now Top a Trillion,” Consumer Financial Protection Bureau, July 17, 2013, http://ift.tt/1apgl5m; The College Board, “Trends in Student Aid 2013: Table 2A: Total Student Aid and Nonfederal Loans Used to Finance Undergraduate Postsecondary Education in Current Dollars (in Millions),” http://bit.ly/Hjw2S6.
2. While the emergence of an ISA market is relatively new, the idea behind ISAs is much older. The idea first emerged in a footnote in Milton Friedman and Simon Kuznets, “Incomes in the Professions and in Other Pursuits,” Income from Independent Professional Practice (Cambridge, MA: National Bureau of Economic Research, 1954), 90, http://ift.tt/1It8kOs.
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