Income-Based Finance Could Teach Education a Lot About Markets

From:  American Banker
By:  Allison Bisbey

Click HERE to read this article and Q&A on the American Banker website (subscription required).  

Should engineering students get more, or more attractive, financial aid than poetry students?

Many colleges charge similar tuition for different degrees. And the federal government charges the same rate of interest for a given type of loan regardless of the school the borrower attends, or his or her field of study. Interest rates on private loans may vary according to a borrower’s current creditworthiness, not future earnings potential.

But what if financial aid, or even tuition, could be priced based on the outcome — a student’s ability to land, and keep, a job?

That is what income-based finance has the potential to do, according to Tonio DeSorrento, founder of Vemo Education, which advises colleges and universities on ways to better align the cost of financial aid packages they offer with the value delivered.

The idea is not new; it is used in some Latin American countries and is being piloted in the United States by some nonprofits. But many of these programs market directly to consumers. Vemo is partnering with colleges and universities, which have their own funding and plenty of potential borrowers.

Purdue University announced in November that Vemo was advising it on a plan to create funds that its students can tap to pay for tuition, room and board. In return, students would pay a percentage of their earnings after graduation for a set number of years, replenishing the fund for future investments.

There is an obvious appeal for borrowers: If they earn less than they expect, they can be sure that their payments won’t be overly burdensome.

Eventually, DeSorrento said, this kind of financing will provide information that schools can use to market their programs and to make them more competitive.

An edited transcript follows.

Where has income-based finance been tried before?

TONIO DESORRENTO: In Latin America, by Lumni, and in the U.S. by a couple of funded companies that tried in the peer-to-peer space. I’d argue they are different concepts from what we are doing today. We’re not recycling people, products or platforms. It’s all from scratch, all applied differently, at scale, in the school channel. There’s one other funded originator [in the U.S.], Cumulus Funding in Chicago. They are doing great. They have a different product, a substitute for short-term/high-interest loans.

Why work with colleges, as opposed to going directly to consumers?

Education is about developing human capital, and income-based finance is an investment in human capital. The use of proceeds is well-aligned with interests of investors; both hope to raise an obligor’s income. American higher education isn’t oriented on employment outcomes, which makes it a less certain investment opportunity in some cases. But college itself is a huge driver of the economy; it delivers a lot of value. Good things happen for graduates, regardless of course of study.

The most valuable way to use income-based finance is to help other good things to happen in higher education. If we can help a college with recruitment or retention, then this pays for itself, the scale is there, the sky’s the limit. We’re not competing with private student loans. We might help people do that [compete with private loans], but the best use [of income-based finance] is solving problems aside from dropping a student’s [effective] interest rate. At root, the value in Vemo for a school is to cause an alignment in cost of education and value delivered.

Will income-based finance replace or supplement student loans?

When we go to a campus, we’re not going to displace a single dollar of federal student loans. Most campuses, at the undergraduate level, have tuition far in excess of federal loan limits; students need either private loans, or sometimes emergency loans from their schools. We help find capital and connect the sources of capital that they [schools] already have with students.

Marketplace lenders are struggling to find borrowers, as are many banks. It’s very competitive. At Vemo, we didn’t want to spend time or resources chasing borrowers. So we go places that already have potential obligors and capital resources (colleges and universities), and create those relationships for them.

Won’t income-based finance tend to encourage higher tuition, just as federally subsidized lending does, by making it easier for students to pay more?

Forgive the lazy hypothetical, but if I’m an investor and you tell me you got into two schools, Party School and Engineering School, and you wanted me to back you for one of them, I’d pick Engineering School. In fact, if Engineering School costs $50,000 a year and Party School costs $40,000, it might be worth it for me to give you $10,000 more each year to go to Engineering School. If Party School costs the same — and it were up to me — I would never let you go there.

The goal for an investor in this case is not to take more money from one graduate [than another], it’s just to get back the same dollar-on-dollar return for the same risk and duration of investment. The lower the likely income stream from an education investment, the lower the amount you would want to invest. But every [course of study] is fundable. To cite an oft-underestimated course of study, poetry graduates don’t starve. They aren’t all professional poets, but they do something [else] that they like and that pays. But an investor might ask a school to deliver that degree less expensively.

In a market dominated by income-based finance, without federal subsidies, schools that delivered less value would have to charge less. But that’s not a system we’re ever going to have. So this is all incremental to the federal student loan system for now.

In general, if a program is viable is today it will probably still be viable, [but] performance on income-based finance products will send signals about employment value.

Will schools offer income-based finance products to all students?

They might, but it doesn’t have to be across the board.

One example is that it could replace an emergency aid program. Most schools have them. Say a parent is laid off; they can’t let you come for free, but they’ll often give you loan, charging you interest, but since you’re in hardship situation, they don’t want to. [Instead] they can use an income-based finance product as a hardship accommodation, and if it works out you’ll pay them back and they’ll help more people, but if it doesn’t, they haven’t layered more debt on you and helped wreck your life. Schools can also use us to target specific programs where loans are a bad fit, or invest with their endowments to bolster value-based recruiting messages.

There are millions of dollars of need for this targeted stuff on almost every campus. Elite schools, mid-tier schools, both privates and publics. That’s where our value is. We’re trying to change people’s behavior in ways that are good for them. The financial product is a byproduct.

What kind of value can income-based finance provide for a particular degree or program?

One is granular data on outcomes. That kind of data can let [schools] make a different argument about the value of their school versus a competitor. Another is alignment. Schools can work with Vemo to structure and finance programs where the school earns more when graduates earn more.

Don’t they need a few years’ worth of data to do this?

Not necessarily. … If the school is getting institutional value — recruitment, retention or otherwise — from an income-based finance program, then pricing on the financial products (and thus performance history) is less important. [A school] doesn’t have to take a wild risk on a person. There’s pretty good info about what happens at different schools over time; you can measure carefully, and decide if want to invest in change. [Say] you’ve got the fourth-best employment outcome, and want the first-best, we can help you manage to that.

And once schools have more data?

We can say, “People in this program underperformed the earnings of people at your peer school’s program; consider doing XYZ.” Schools using income-based financing have an incentive to respond, and not just for the good of the graduates. There are big opportunities [for Vemo and others] here because most colleges don’t have the budgets to gather actionable data, much less invest in solutions, and we help provide that.

If there’s a flat tuition, is poetry subsidizing engineering?

For any risk and duration combination, you’re looking for similar dollar-on-dollar return. We work [on programs] that are priced across many courses of study at some schools. The goal up front is for every student to receive similar terms, dollar-on-dollar, but there’s always a range of outcomes. Some people will overachieve, others underachieve, and they will cross-subsidize that way.

What other potential uses are there?

People might say, “If you agree to teach low-income students or perform a public service, there’s forgiveness.” Or a state university might say, “You [only] have to make payments if you move out of state. Every month you are in-state you get a deal, and every month you are not, you pay [a percentage of your income]” — which would approximate the forgone state income tax from a state with brain drain. We’re not there yet, but this will be used one day as a kind of precision social impact bond.

Does income-based finance lend itself to securitization?

Yes, though there isn’t an immediate securitization story. One day our work with colleges and universities will help the market better understand this asset class, and an enterprising banker will find us.

 

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