• Paying for College
    An Alternative To Student Loans

    By Mark Keightley

    17-06-2016

    The views expressed herein are those of the author and are not presented as those of the Congressional Research Service or the Library of Congress.

    Outstanding student loan debt in America currently exceeds $1.3 trillion. Talk of rising college costs, fear of an impending student loan "bubble" burst, grim implications for marriage, homeownership, and retirement, and macroeconomic consequences have raised concern among parents, students, economists, and policymakers.

    Is there anything that can be done to address the current student loan debt situation? This is a complicated question, but it cannot hurt to begin to explore potential alternatives to loan financing, even if the alternatives may eventually lead to a dead end. The list of financing options is long: universal college, increased grant funding, tax incentives, lower student loan interest rates, part-time employment in college. Most of these have been discussed in academic journals or the popular press at great length so the value added detailing the pros and cons of each in this post would be marginal.

    An option that has received far less attention, however, is the use of human capital contracts (HCCs) to finance college.  An HCC is an equity instrument whereby a student agrees to pay an investor X percent of their future earnings for Y years in exchange for Z dollars upfront to pay for college. Some students may not end up paying back as much as initially expected due to lower than expected earnings, while others may pay back more than expected due to higher than expected earnings. In any case, students' repayment burdens always remain proportional to their incomes, unlike with some student loans. Investors can minimize their risk and maximize their expected return by investing in a diversified pool of students.

    HCCs are already on the radar. Lumni currently offers HCCs to fund students' educations in South and North America. In 2009, legendary investor Warren Buffett raised the idea during a 2009 CNBC Town Hall event. Mr. Buffett offered $100,000 to any of the Columbia MBA students in the room in exchange for 10% of their earnings, emphasizing that his offer implied a valuation of a least $1 million per student. He upped his offer to $150,000 if students improved their value by learning better communication skills, placing their enhanced valuation at $1.5 million. Even professional athletes have attempted sell off a stake in their future earnings in exchange for upfront funding in recent years.

    Would all HCCs have the same income sharing requirements and repayment terms? The answer is no, and that is potentially the answer to one of the perceived problems with student loans. Currently, most federal student loan terms are standardized for all borrowers - a dance major is eligible to borrow the same amount at the same interest rate with the same repayment term as an engineering student. With reasonable certainty, however, the average dance major will earn less than the average engineering major.  There is a disconnect between the cost of the educational investment and the expected return to the investment in the form of earnings. This potentially skews the allocation of resources toward less productive (measured in terms of earnings) educational investments. As a result, there is underinvestment in some fields and overinvestment in others. Additionally, students graduate with similar debt burdens but sometimes drastically different earning power.

    In contrast, the terms of HCCs would depend on expected earnings of each student. In the example above, investors may be willing to finance the dance major's education with a $50,000 investment in exchange for a 12% claim to his income over the next 20 years, but may be willing to offer the engineering major $100,000 in exchange for 10% of his income over the next 10 years.

    If a well-developed market in HCCs were to be developed, students would able to see what financing terms were associated with various majors. In addition, HCC financing terms would likely be school- or school-tier-quality contingent, with the terms for attending the best schools being most favorable for a given major.

    In the end, students would find it in their interest to weigh the costs and benefits of potential majors and schools. For example, while a small expensive private school may have a highly respected dance program, HCC financing terms may incent a potential student to consider earning an economics major along with a dance minor at a lower-priced state school. This, in turn, could introduce some discipline on rising tuition as schools would no longer have the same ability to increase prices on students whose financing depended on what school they attended.

    The same features of HCCs that may result in more market-oriented incentives also present some outcomes that could cause hesitation for embracing such an approach. For example, females would likely be offered less favorable financing terms compared to identically situated male students. The reason being that women are (naturally) more likely to leave the labor force to give birth, and since HCC investor returns depend on the future expected earnings of students, they will price HCCs offered to women higher to compensate for the potential drop in their expected return. Lawmakers could enact legislation that prevents considering gender when underwriting HCCs, in which case the extra cost would be shared across genders.

    Some students may not be offered financing at all if investors deem them to be too risky, perhaps because of past educational performance, major choice, or desired school. This may be viewed as unfair to those who believe college should be accessible to all. Proponents of HCCs would argue, however, that the market is signaling to these individuals to consider an alternative to college (e.g., trade school), pick a different major, or choose another school. Again, policymakers could step in and ensure the availability of traditional student loan or grants financing for such students.

    Other students may come to view the HCC they entered into as unfair after the fact. For example, some students with particularly bright future career paths may not want to take the risk of using an HCC if they could end up repaying investors an amount that is disproportionate to what they received to finance their education. Complementing HCCs with human capital options could help mitigate such outcomes. Students that fear paying back a disproportionate amount of their future earnings could protect themselves by purchasing an option that gave them right, but not the obligation, to buy back a specified portion of their future earnings after they graduate.

    Numerous other important issues surrounding HCCs exist, and careful consideration would be required before replacing or augmenting the student loan approach to financing higher education with HCCs. Readers interested in a more detailed discussion about HCCs and the relevant issues may find the following book and references within useful:

    Investing in Human Capital: A Capital Markets Approach to Student Funding, by Miguel Palacios Lleras.

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  • The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.

Mark Keightley

Mark Keightley is an economist with the Congressional Research Service (CRS) in Washington DC. His research areas include corporate and business taxation, housing taxation, financial securities taxation, and macroeconomics. He serves as an adjunct professor in the School of Policy, Government, and International Affairs at George Mason University where he teaches graduate-level courses in macroeconomics, microeconomics, and investment. Mark was previously an associate at the Congressional Budget Office, a visiting scholar at the Federal Reserve Bank of Saint Louis, and an adjunct professor in the economics department of The George Washington University. He earned a BS in economics from the College of Charleston, and an MS and PhD in economics from Florida State University.

* The views expressed herein are those of the author and are not presented as those of the Congressional Research Service or the Library of Congress.

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