Posted by Jared Meyer and Franziska Kamm
Cross posted from E21.
As student loan debt has almost tripled since 2004, start-up companies such as Upstart and Pave offer a solution. These firms allow those with excess money to invest in people and their careers. Graduate students from competitive universities are especially attractive targets for investors. As their business models continue to develop, they could help alleviate problems in the broader student loan market.
Companies such as Upstart and Pave offer a promising new concept that has already begun successful operation without using taxpayer money. Upstart raised an initial round of funding of $1.75 million from such prominent backers as Google Ventures, New Enterprise Associates, and Kleiner Perkins. This stands in sharp contrast to the government’s $169 billion a year programs of Pell Grants, student loans, and tax credits.
Outstanding student debt exceeds $1 trillion and 40 million graduates are saddled with an average of $25,000. For those who fail to graduate, the burden is even heavier. Nine percent of graduates default within two years, and overall delinquency is 15 percent. The need for steady income to repay this debt forces young people to find employment as soon as possible instead of looking for career paths that are right for them.
With Upstart and Pave, investors are repaid through percentages of borrowers’ monthly salaries for a period of up to ten years. To determine individual rates, the companies use algorithms that calculate likely future earnings based on university, major, grades, and professional experience. This rate usually lies between 4 percent and 7 percent of income and enables investors to make informed decisions while weighing risk and return.
An important secondary effect is that investors have incentives to mentor those in whom they have financial stakes. They can offer personal advice and introduce their “investments” to professional networks. If the loan recipients’ careers take off–and their salaries increase–the investor’s return rises. It is in the interest of both parties for young people to succeed.
Many borrowers find this opportunity liberating. The personal relationship provides these loans with a feeling of opportunity that further motivates.
While investors may attempt to influence young peoples’ careers, borrowers are free to choose any major or career after receiving the loans.
If Pave’s borrowers’ incomes fall below 150 percent of the poverty line, they are allowed to defer repayment. Upstart’s borrowers do not owe anything if they make under $20,000 a year, but the repayment period can be extended. Whereas traditional student loans cannot be shed in bankruptcy, if necessary, these innovative loans can.
These companies make money on successful use of their proprietary algorithms when determining borrowers’ future incomes. If they rate students’ prospects too high, or too low, their credibility will suffer and other firms will take their places. Here, unlike with government loans, there is still open competition which, over time, drives down costs for all parties.
The business model has another benefit. Students who choose degrees in high-return, in-demand majors, such as engineering or computer science, will receive an economic incentive for doing so–paying a lower percent of their future salaries.
This exposes additional issues with the current student loan system. The same rate (3.86 percent as of this school year) applies to all undergraduates irrespective of field of study, test scores, or high school GPA. The economic misinformation that comes from offering such low rates across-the-board causes many students to choose a four-year university when there are better options. As Diana Furchtgott-Roth, a senior fellow at the Manhattan Institute, has shown, it is a better investment for many high school graduates to choose two-year colleges over four-year universities.
Offering low-interest loans to everyone also contributes to college’s rapidly increasing costs (now over $40,000 a year for a private four-year education). This “Bennett hypothesis” was first formulated by William Bennett in 1987 when he was Secretary of Education. He claimed, “increases in financial aid in recent years have enabled colleges and universities blithely to raise their tuitions, confident that federal loan subsidies would help cushion the increase.”
As with any successful start-up, existing business models are threatened. Those who stand to lose from companies such as Upstart and Pave (large financial institutions, underperforming colleges) will use any hiccups the companies encounter as evidence for excessive government regulation. Instead, the government should use its strength as an enforcer of legitimate contracts to ensure human capital investments receive the same legal treatment as other student loans (except allow them to be shed in bankruptcy).
While this innovative financing idea will undoubtedly need time to grow and improve, entrepreneurs require freedom to experiment with what works best. Allowing competition will go a long way towards helping this natural process. What is unquestionable is that the status quo is unacceptable and change to education financing is necessary.
In ten years, more young people might finance their education or business through human capital investments. If regulators’ grips on the industry become too tight, and squeeze out innovation, we will never know what could have been.
