ISAs: A novel alternative to private student loans?

If college is an investment, students don't have to be the only ones reaping the returns. Or for that matter, taking on the risks.

In one novel alternative to private student loans, investors could front students the money to pay for college in exchange for a percentage of their future earnings. But what are the dangers to students who accept these so-called income-share agreements? Who would benefit the most?

This week, Purdue University took a step toward answering some of those questions by partnering with Vemo Education, a Virginia-based financial services firm, to explore the use of income-share agreements, or ISAs, to help students pay for college.

Through its research foundation, the school plans to create ISA funds that its students can tap to pay for tuition, room and board. In return, students would pay a percentage of their earnings after graduation for a set number of years, replenishing the fund for future investments. Purdue is relying on Vemo, along with nonprofits 13th Avenue Funding and the Jain Family Institute, to flesh out the terms.

There's nothing new about ISAs. Economist Milton Friedman floated the idea in the 1950s, and a handful of Latin American countries use the agreements. Yet they have been slow to catch on in the United States. A handful of small companies and nonprofits, including Cumulus Funding and 13th Avenue, are piloting programs or offering contracts on a limited basis, but the market is in its infancy.

Last year, Sen. Marco Rubio, R-Fla., and Rep. Tom Petri, R-Wis., introduced legislation to create a legal framework for ISAs that set the maximum length of a contract at 30 years, capped income at 15 percent and stated that the agreements are not loans. The bill stalled in committee but brought attention to the nascent market.

Purdue President Mitch Daniels, the former governor of Indiana, championed income-share agreements in a recent Washington Post op-ed, calling the contracts "a constructive addition to today's government loan programs and perhaps the only option for students and families who have low credit ratings and extra financial need."

He wrote:

"From the student's standpoint, ISAs assure a manageable payback amount, never more than the agreed portion of their incomes … Best of all, they shift the risk of career shortcomings from student to investor: If the graduate earns less than expected, it is the investors who are disappointed; if the student decides to go off to find himself in Nepal instead of working, the loss is entirely on the funding providers, who will presumably price that risk accordingly when offering their terms. This is true "debt-free" college."

Is it really? Income shares certainly don't function like traditional debt in that there is no explicit principal balance or interest. And the repayment terms are in many ways more flexible than even the most generous of the government's income-based repayment plans.

Still, ISAs are debt in the sense that they obligate students to essentially repay a portion of the investment. And depending on a graduate's earnings, an ISA could become an expensive way to finance an education.

Say a student agrees to pay five percent of her income for five years on a $10,000 agreement. If that student lands a $60,000 job after graduation, she could pay $15,000 by the time the contract is up, more if she gets raises along the way. Yet if that same graduate loses her job during that time, she wouldn't be forced to find the money to pay.

Either way students would have to be pretty informed about the earning potential in their field before signing up. Some observers worry that students pursuing profitable degrees in engineering or business would get better repayment terms than those studying to become nurses or teachers.

But there are ways to avoid that sort of adverse selection, says Tonio DeSorrento, chief executive at Vemo.

"It's easier to scale [the agreements] and meet both investors' and students' needs if you fund people in groups," said DeSorrento, who co-authored a paper on ISAs with Andrew Kelly at the American Enterprise Institute.

By pooling agreements, investors could hedge against graduates who might wind up with low earnings or lose their job, he said. Agreements could also be grouped by field of study or other characteristics, so students are judged relative to their peers.

And student protections? That's a little fuzzy, meaning it would be up to policymakers and regulators like the Consumer Financial Protection Bureau to determine which consumer protection laws would be applicable to an ISA. Since the agreements aren't exactly loans, it's unclear whether they'd be subject to laws like the Fair Credit Reporting Act, for instance.

All of the uncertainty surrounding ISAs, and all of the potential, is what makes the Purdue experiment so interesting. The structure of and demand for the program could encourage other universities to sponsor their own funds.