Fortunately, there are two exciting financing methods that can put an end to future student loan defaults. The first option is income share agreements (ISAs). These agreements, sometimes called human capital contracts, are essentially equity investments in a student’s education. An investor pays the costs of a student’s education in return for a portion of the student’s future earnings for a set amount of time. Purdue’s Back-a-Boiler program is the most prominent example of an ISA.

The second financing method is income contingent lending (ICL), a close cousin of ISAs, but where the contract is an open-ended loan rather than equity investment. Thus, a typical ISA may require a student to pay 10% of income for 10 years, whereas an ICL may require 10% of income until the loan is paid off. ICL is used in Australia and Britain, and to a limited extent in the United States.

ISAs and ICL have several advantages over traditional student loans. Most importantly, it renders student loan defaults a thing of the past. Since a student’s required payment adjusts based on their income, students are never put in the situation of not being able to afford payments. If a new graduate can’t find a job during these troubled times, an ISA or and ICL would automatically adjust their payments down to $0, and once they find a job, their payment would automatically adjust up.

Another benefit of ISAs and ICL is that they allow students to smooth their consumption over time. A traditional loan with a fixed monthly payment will absorb a high share of a student’s income when they are not earning much, and a small share of income when earnings are high. In contrast, payments move with income under ISAs and ICL, leading to more stable after-payment income.

But while both ISAs and ICL are better than the current student loan system, there are four main reasons income contingent lending (ICL) is superior to income share agreements (ISAs).

1. Income contingent lending suffers less from adverse selection 

ISAs suffer from severe adverse selection because the percent of income repaid doesn’t depend on earnings. Students expecting to have high earnings (e.g., doctors) will avoid ISAs, whereas students who expect to have low earnings will flock to ISAs. This adverse selection reduces the appeal of ISAs to investors since they know the pool of applicants will be disproportionately composed of low earners. In contrast, ICL has less of a problem with adverse selection. High earners will simply repay their loan more quickly, and therefore won’t avoid ICLs to the same extent that they would ISAs.

Another factor limiting adverse selection for ICL relative to ISAs is that it is more difficult to predict which students will be profitable and which will cost the lender money, making it more difficult for students to self-select out of ICL.

2. Income contingent lending has less moral hazard 

Students might alter their job choices and or negotiate for larger non-cash benefits such as more vacation time under both ISAs and ICL. But these problems are worse under ISAs due to the fixed length of the contract, which creates a more adversarial relationship between the student and the investor. For example, students have an incentive to hide as much income as possible from investors since they never have to pay on any income they successfully hide. ISAs will therefore be subject to some fraud and unethical behavior from borrowers. In contrast, with an ICL, if a borrower hides income, not only does that not reduce what they owe the lender, they will owe the lender more interest as a result of hiding income. Thus, compared to ISAs, ICL better aligns the interests of borrowers and lenders.

3. Income contingent lending benefits from continuous competition 

Competition among lenders/investors is the best safeguard for consumers. ICLs benefit from competition throughout the life of the loan. If at any point, the student can find a better interest rate, they can simply refinance their loan. In contrast, with an ISA, there is only competition once, when the educational investment is first made. After the initial investment, there is no “outstanding balance” and therefore no way to refinance, leaving students without the protection of continuous competition.

4. Income contingent lending has fewer public relations problems

ISAs also suffers from at least two public relations problems that ICL largely avoids.

First, as Milton Friedman noted, ISAs are “economically equivalent to the purchase of a share in an individual’s earning capacity and thus to partial slavery.” Later scholars have tended to liken ISAs to indentured servitude rather than slavery. Miguel Palacios Lleras makes a convincing argument that either analogy is incorrect—that unlike under slavery or indentured servitude, the student retains full freedom of action. Miguel is right, but that doesn’t make winning the PR battle much easier. In contrast, ICLs are loans, and everybody already accepts that repaying your loans is expected of responsible adults.

A second public relations problem is differential pricing based on characteristics like biological sex. ISAs need to front-load any differential pricing, varying the terms of the initial agreement. But for ICL, the terms of the loan can be the same, with differential pricing only occurring based on the pace of individual borrower repayment.

To see the difference, consider an otherwise equivalent young man and woman. Since there is a greater probability that the woman would at some point give birth and exit the labor market temporarily, investors will tend to ask for a higher percent of income or a longer term of repayment from the woman to compensate for this risk. This will be a PR disaster for ISAs. In contrast, an ICL could offer the same up-front interest rate to men and women, with women that leave the labor market temporarily due to childbirth simply taking longer to repay the loan and hence paying more interest.

(For more details, see Texas Public Policy Foundation’s recent study, Unleashing Market-Based Student Lending.)

To be sure, both ICLs and ISAs are better than the current student loan system. And both would effectively end student loan defaults. But income contingent lending is superior to income share agreements and policymakers should therefore prioritize the implementation of income contingent lending.