Last year, the Illinois state legislature enacted the Student Investment Account Act, a law that gave the state treasurer’s office $800 million to provide debt financing to current and former college students in the state. The law provided $200 million for low-interest loans and $500 million for refinancing loans, and stated that up to $50 million of those funds could be used for income share agreements (ISAs), should the state treasurer’s office decide to do so. The information provided in Illinois’ exploration of whether to offer state ISA loans in the future suggests that states seeking to use the concept of income sharing as a way to make college affordable and reduce student debt have their work cut out for them.

The Illinois Process

In Illinois, state policymakers face core decisions in how to implement this new law. This past summer, stakeholders participated in “policy lab” meetings organized by the Milken Institute to provide input into how the state treasurer’s office should craft the various loan products authorized by the legislation. In the subsequent Milken report, participants highlighted an important question that the state will need to answer if it uses these funds to offer ISAs at some point in the future: Will the state take external capital investors, or fund the program themselves?

The question they posed will ultimately help determine how expensive these products are for students, and underscores a core flaw to common claims that an ISA loan solves the large-scale affordability problems plaguing our higher education system. Many ISA providers highlight their product as avoiding student loans or a solution to debt, making college more affordable. In reality, some ISA loans may actually be more costly to the student than even a traditional private loan, depending on the terms and conditions in the loan contract. High costs can result from a confluence of three factors: (1) the returns demanded by private investors; (2) the difficulty that a student may have in assessing total cost of the product, particularly given the lack of adherence by many providers to traditional disclosure rules; and (3) the insistence by industry that these products are not loans, and thus do not need to follow basic consumer protections such as usury laws.

If the state treasurer’s office decides at some point to move forward with offering state ISAs and takes guidance offered by some of the lab participants, it may help avoid the worst of those problems. According to the Milken report, some participants who gave feedback encouraged the office to pursue a product design that meets existing state student loan regulations and includes an annual interest rate of 2.5 percent, and that the cost/capital return of the ISA loans be indexed to below the rate of return for Department of Education loans.

However, potential service providers have focused less on those actual costs. There has been limited discussion of the overall cost to the consumer in industry responses to the treasurer’s request for information from service providers, or from the RFP responses for strategic investment advising for the treasurer’s investment account (all proposals submitted to the treasurer’ office are available here). Several industry respondents float the possibility that a state-backed ISA product may eventually rely on a variety of types of external capital as it expands past the pilot phase. As one industry respondent states, outside financing for any of these products means that “there are yield limits that will drive overall pricing”—in other words, investor pressure will drive costs up to meet their demanded return.

The basic market dynamic of investors seeking certain returns is not surprising or new in student lending, even for state-provided loans: investor demand for certain returns exists when states offer traditional state-backed loans financed at least in part by external capital. With those traditional loans, it’s at least easier for students to benchmark whether the product is offering a better deal than other options; while some RFP and RFI respondents talked about a traditional state-backed loan product designed to “beat the PLUS” (the more expensive Department of Education federal loan available for parents or grad students), it wasn’t clear that those cost metrics would apply to the ISA loans. And the ways that ISA loans have been marketed make it much more difficult for students themselves to benchmark the offering against other options.

More broadly, the reliance on private capital markets in either state-backed products or in private ISA products highlights the core challenge to the ISA loan proponents who want to see these products take off across the market to “fix affordability.” If capital provided is not significantly subsidized, through philanthropy or governmental investment, then the product will not necessarily be any more affordable, in aggregate, than other private loans in the market; absent a subsidy provided by the state or other philanthropic entity, investors will either demand a higher return or simply move their dollars elsewhere. (And, even if the capital is subsidized, which some RFP respondents do suggest, the terms themselves may mask an overall cost that is higher, in aggregate, to students than already expensive alternatives.)

Some of these challenges may be partially addressed in Illinois if the state passes proposed legislation (co-led by the Treasurer’s office) that would clarify that ISA loans will remain regulated like other financial products, specifically under the Consumer Installment Act, and with payment caps that keep the loans far more affordable. And, even without that legislation, if the state treasurer decided to offer an ISA loan in the future, he has the opportunity to offer a fair and comparatively cheaper product.

Regardless of what happens in Illinois, the failure to truly address affordability will remain a feature in the ISA loan market writ large, and comes with a major warning sign. While state policymakers are understandably concerned as they face major budget challenges in the wake of COVID-19, and are historically prone to seeing their higher education budgets as a place to cut costs, relying on private loan financing as a quick fix to student debt and affordability challenges may actually result in states pushing significant debt onto already financially overburdened students.

Cover Photo: Illinois Treasurer Michael Frerichs speaks at Malcolm X College. Source: Facebook/Treasurer Michael Frerichs.