Yesterday, I described Income Share Agreements (ISAs) as basically a version of Milton Friedman-like Human Capital Contracts, which are very much like privately administered graduate taxes.  The question we will answer today is: under what circumstances would a private ISA be preferable to a public student loan?

Assuming both were equally available and equally subsidized, then in theory a student would be indifferent between the two.  But there are a few reasons why this is unlikely to be the case; and understanding these is key to understanding when and where ISAs make sense.

First, public loan systems are, for the most part, subsidized.  In the Canadian system, the governments cover all interest while a student is in school (or longer – see the BC example from last month), subsidizes loan repayments for low-income graduates through the Repayment Assistance Plan (RAP) and covers losses from loan defaults.  The federal government covers this partly through charging students higher interest during repayment, but there is still a residual which requires a government subsidy to cover.  Unless ISAs are similarly subsidized (which they could be, if they are philanthropically funded), they will be less attractive to student loans.

Second, the unknown nature of the ultimate payment under an ISA creates some adverse selection effects.  If you think you are going to make a lot of money after graduation, you would prefer a student loan, which limits your liability, over an ISA under which you may repay many times the amount you initially borrow (this ISA, at Purdue University, caps total payment at 2.5 the initial investment, which is still a heck of a lot).  This means students from programs that lead to high-paying jobs (medicine, dentistry, MBAs, etc.) will probably not be inclined to use it.  On the other hand, if you think you may not earn very much, you may find it more advantageous to be in an ISA than taking a loan.

This, as you might imagine, creates a huge whack of moral hazard: your plan will be overwhelmed with students with low income-prospects.  To prevent this, what happens is that ISA providers simply change up the terms of their agreements to make sure that they break even no matter who shows up in the program.  If they have a lot of low-future-income students, they will just lower the income thresholds and increase the repayment percentage to compensate.  This is why some experts = like these folks at the Roosevelt Institute – see almost no difference between Income Share Agreements and student debt from the student point of view.

I argue that there are perhaps two good arguments in favour of ISAs.  The first is that they can supplement existing student loans.  Governments don’t provide unlimited amounts of money to students and frequently the maximum (currently a little under $12,000 for most students in most parts of Canada) doesn’t cover both tuition and living expenses.  So, a loan might beat an ISA, but an ISA is better than nothing.  That said, it’s not entirely clear why in such circumstances a lender would prefer to offer an ISA over a loan.  Why not just offer another loan?  It’s not like the collection costs associated with an ISA are any lower than those for a conventional loan.

The second argument is that ISAs are best for students who are debt-averse might not be equity averse.  Pure debt-aversion is, I think, over-rated as a financial impediment to access, but it certainly has been proven to exist, though not in the way most people argue it does (key point: it does not appear to be linked to income background).  Arguably, ISAs are a niche instrument to offer the debt-averse equity-based assistance instead of debt-based assistance.  I am a bit skeptical that this would work – and there is no empirical evidence that would prove this one way or another – but I suppose it couldn’t hurt to try.

Here’s the bottom line: if, at the end of the day, the lender/investor has to cover their cost of capital, then the difference between debt instruments and equity instruments from the borrower’s perspective is pretty small.  Conceivably, private ISAs have a role as a supplement to conventional loans or as a niche alternative to students who refuse to take on debt for whatever reason (ISAs could, for instance, easily be made sharia-compliant).  But for the most part, increased lending with better targeted debt relief is a better alternative.