An educational investment is an agreement between a sponsor and a student, where the sponsor agrees to provide the student with funding for his or her college education in exchange for a fixed percentage of the student’s income after graduation for a set period of time.
This is in contrast with traditional student loans with level repayment plans, where the borrower agrees to pay a fixed dollar amount each month for a set period of time.
Educational investments shift the risk of failure from the borrower to the investor. If the borrower does not get a good job, there is no guarantee that the earnings will be sufficient to repay the investment, let alone, a return on investment. This risk-shifting benefit may be especially attractive to low-income students, who tend to fear debt due to a lack of experience with loan indebtedness. The prospect of borrowing more for their education than their parents earn in a year can have a chilling effect on college enrollment by low-income students.
On the other hand, if the borrower earns a high income, the borrower may end up paying a lot more than he or she would have paid on a traditional student loan.
History of Educational Investments
The idea for educational investments finds its roots in the concept of a human capital contract, as developed by Nobel Laureates Milton Friedman and James Tobin. From 1971 to 1978, about 3,900 Yale University students agreed to pay 0.4% of future earnings for 35 years for each $1,000 received. Participants could buy out their repayment obligation by paying 150% of the principal balance plus interest. This program was known as the Tuition Postponement Option (TPO).
Similar ideas are proposed periodically. Examples include MyRichUncle in early 2000 (filed for bankruptcy in 2009), Lumni in 2002 (entered the U.S. in 2011), an educational investments fund at U.C. San Diego established by philanthropist Michael Robertson in 2004, College Degree Fund in 2008, SponsorChange.org in 2009 (rewards volunteer work), Enzi in 2010, the Fix UC proposal in 2011, a medical-school debt proposal by Reddi and Thyssen in 2011, Oregon’s Pay It Forward, Pay It Back proposal in 2013 (and similar proposals in Pennsylvania, Ohio and Michigan), Pave in 2012, 13th Avenue Funding in 2013 and Gradible.com in 2014 (perform online tasks to repay student loans).
Variations on this idea have fueled education loan products, including MyRichUncle’s private student loans, the Human Capital Score from People Capital in 2009, and the launch of education lenders SoFi in 2011, CommonBond in 2012 and Upstart.com in 2012.
A variety of student loan repayment plans with loan payments based on the borrower’s discretionary income have been introduced in the U.S., including income-contingent repayment (ICR) in 1993, income-based repayment (IBR) in 2007 and pay-as-you-earn repayment (PAYER) in 2011. Since the repayment obligation is based on a small percentage of the borrower’s discretionary income, the monthly payments are automatically affordable (and zero during periods of economic hardship or in-school deferment) but may require a repayment term of two or more decades. Similar loan repayment plans are available in other countries, including Australia, New Zealand and the United Kingdom.
Several patents have been issued relating to educational investments, including U.S. Patents 5,809,484 (1998) and 5,745,885 (1998) to Anthony J. Mottola, Julius Cherny and Roy C. Chapman of Human Capital Resources Inc., and U.S. Patent 8,374,933 (2013) to Sallie Mae.
Educational investments are sometimes called sponsorships or income-share agreements.
Flaws Affecting Educational Investments
Proposals for educational investments often suffer from several design flaws, such as:
- If participation is voluntary, adverse selection may disproportionately attract students who intend to pursue low-paying occupations, who are more likely to benefit from a lower repayment obligation. Effectively, this creates a cross-subsidy from high-paying occupations to low-paying occupations, which may not align with the needs of employers. Students who expect to get high-paying jobs may opt out of the program in favor of traditional student loans.
- There is a potential moral hazard problem, where participants may borrow excessively, knowing that they are unlikely to ever have to repay the debt in full.
- Regulation of educational investments like loans may cause the repayment obligation to violate usury laws for some students. Educational investments that do not adjust the obligation according to the benefit received by the participant are not fair to students who would otherwise have a small amount of debt or high income, since the repayment obligation may exceed the financial value of the proposal by an order of magnitude. Such educational investments may be less attractive to low-income students who get full financial aid packages from external sources and wealthy students whose parents can pay for the full cost of education. For example, if a student would otherwise need to borrow only a few thousand dollars, but is required to repay tens of thousands of dollars, that’s the equivalent of a very high interest rate.
- Proposals often underestimate the costs of completely replacing student loan debt, fail to adjust repayment obligations for tuition inflation, fail to consider the potential for participant default and fail to consider the need for initial start-up funding.
- Participants may still have to borrow for some college costs, so the proposals do not necessarily eliminate all student loan debt, despite claims to the contrary.
- State proposals overlook the difficulty of enforcing a repayment obligation and collecting payments if the participant moves to a different state or out of the country. The proposals may even incentivize students with high-paying jobs to move out of the state, causing a brain drain.
- The proposals often assume a repayment obligation that lasts for decades, which is longer than what most participants will tolerate.
- The design of educational investment proposals often implicitly shifts more of the burden of paying for college from the government to the families.
- Investors often lack information about the cash flow characteristics of educational investments, making them reluctant to invest significant sums of money in such arrangements. As a result, educational investments rarely go beyond a pilot stage.
Evaluating Educational Investments
Students who are considering an educational investment should compare the costs of the educational investment with the costs of a traditional educational loan. One approach is to compare the total expected payments under an educational investment with the total expected payments under a student loan of comparable maturity. Using a similar repayment term avoids some of the need to discount the cash flows using a net present value calculation.