Student Loans Could Be the Next Mortgage Mess. Here’s a Radical Fix

Sheila Bair, who as head of the Federal Deposit Insurance Corporation from 2006 through 2011 was one of the few officials to warn of the 2008 mortgage crisis, is now hoping to forestall a similar mess in student loans.

Her solution: a new kind of college funding option that would let students trade away a portion of future earnings for financial support now.

Since taking over as president of Washington College in Chestertown, Md., in 2015, Bair has noted parallels between the rise of student indebtedness and the mortgage bubble that sparked the Great Recession. High student debt can have "tragic consequences," she says. "It deters kids from starting businesses. That drags down economic activity. It's the same dynamic as the mortgage crisis."

She tells Money she is now looking for donors to create a $1 million “educational investment” fund. The account would pay some of the bills of Washington College upperclassmen who need funding beyond scholarships and federal student loans. After graduating, they would repay the fund a percentage of their income.

She believes the option -- sometimes referred to as “deferred tuition” or “income share agreements” (or ISAs) -- is better than a high-interest parent or private loan because “it automatically adjusts with the student’s income, so it is always affordable. It relieves financial distress.” Graduates who lose their job or take a low-paying job won’t be hounded for ISA payments they can’t make, she says.

Bair is one of the highest-profile supporters of ISAs, which have been gaining some traction over the last couple of years. Several coding bootcamps have started to waive upfront tuition in return for a percentage of their graduates’ income. Last fall, Purdue University became the first traditional university in the country to launch broadscale experiment in ISAs. About 150 upperclassmen have gotten funding from the public Indiana school’s “Back a Boiler” fund, which requires students to pay about 3% to 5% of their post-graduate income for anywhere from seven to 10 years for every $10,000 they receive. (The rates and payback periods depend on the student’s year and major.)

While only 7% of Americans had heard of ISAs, according to an American Enterprise Institute survey released last week, over half liked the idea once it was explained. The poll indicates “there is enough interest among parents and students to support an ISA market that is much larger than the one that exists today,” says Jason Delisle, the resident fellow who oversaw the survey.

(Here's a list of schools and programs offering ISAs for accredited colleges.)

One Big Caveat

Delisle points out a downside of ISAs, however, noting that they tend to be more expensive for undergraduates than current federal student loans. Undergraduate federal loans currently charge interest rates below 4% -- making them the lowest-cost funding available other than scholarship grants -- and already offer income-based repayment options, he points out.

The problem is that the U.S. Department of Education limits traditional undergraduates to a maximum annual student loan of $5,500 to $12,500, depending on the student’s age and year. (Traditional undergraduates can only borrow $5,500 as freshmen. Adult students can borrow up to $12,500 a year.)

Of course, many students need more than that. Even after subtracting out the average scholarship, the typical student at an in-state public university pays a net price of about $18,000 a year. And undergraduates at private colleges end up paying more than twice that amount, on average.

As a result, many students who need additional funding feel they have no choice but turn to federal parent loans, which charge about 7% in interest this year, or private loans, which charge market rates. For most people, ISAs will end up being much more flexible and affordable than those loans, Delisle says. But for those who land high-paying jobs, an ISA would be the more expensive option.

Bair says Washington College is working on the details, trying to balance the fund's repayment need with a desire to make sure that students get a reasonable deal. Washington is considering charging 1.5% of a graduate’s income for every $10,000 in funding for the first five years, she says, then 2% for the next five years -- with a similar .5 percentage point increase in income-based payments every five years until 150% of the original amount is repaid or 20 years have passed.

That would probably be a slightly better deal than a 7% loan, which would offer no payment flexibility and would require a student to end up repaying a total of $15,000 over 10 years. “I think it has a lot of appeal,” Bair says.

This story was corrected at 1:13 p.m. 1/31/2017 to correct the spelling of Jason Delisle's last name.