Can Outcomes-Based Financing Help Solve the Loan Crisis?

Starting this academic year, graduate students will face new federal borrowing limits, driving some to private lenders and leaving others without a way to finance their education. But a group of bipartisan lawmakers and policy experts believes they have a solution to this funding gap: outcomes-based financing.

Now, they’re looking to pass a bill that would make it possible.

Introduced last month by a group of bipartisan, bicameral lawmakers, the Outcomes-Based Financing for Students Act is designed to create a framework that helps a lender tie students’ loan access to their earnings after graduation rather than to their credit history. It includes safeguards such as capping payments at no more than 20 percent of a student’s income, providing additional protections for lower-income students who earn less than 350 percent of the federal poverty level and requiring clear, standardized disclosures about what borrowers are getting themselves into before they sign on the dotted line, among other things.

The lawmakers say they hope to “expand access to innovative financing options for students pursuing postsecondary education and workforce training.”

To develop the bill, the lawmakers worked with policy experts from Jobs For the Future, a nonprofit group focused on workforce and economic development. Inside Higher Ed spoke with Ethan Pollack, a senior director at JFF, to break down how these loans work, why they matter now and how they might address today’s challenges while preparing students and colleges across the country for the years ahead.

The interview has been edited for length and clarity.

Q: Let’s start with the basics: What exactly is outcomes-based financing?

A: Outcomes-based financing is any type where how much the students repay is in part based off of their earnings. This can be done in a couple ways.

The easiest way is what you might call an outcomes-based loan, which is like a normal loan, except the repayments have some type of income contingency. So a good example of that would be an earnings threshold. In any given month, if the student is earning below a certain threshold that’s set in the contract, then they would make no payments in that month. You can also have a time-based obligation, where after a period of time, no matter how much the student has repaid, at the end of that period of time, their obligation to pay expires.

You can also design it as an income-share agreement as well [which offers students up-front financial support in exchange for a portion of their future earnings for a set number of years]. There’s some subtle differences. ISAs can potentially be a little more complicated and harder for the student to understand. Providers usually have to do a lot more work in making sure that this is something that actually students understand they’re signing up for.

In both cases, you are trying to tailor how much the students pay to how much they’re earning over a period of time, and that in theory—if these are designed well, which is a big if—can make education over all more affordable.

Q: It sounds like you think this can be a better solution than traditional fixed-rate loans for some students. Why is that?

A: First off, it can be a better option. It’s not always a better option; it depends on whether it’s designed well.

So, how? I think in two ways: One, it can be more accessible to students who have thin credit files or do not have parents that can co-sign. Outcomes-based financing payments are based more on outcomes. That means the underwriting and the criteria of eligibility for these products can be designed to de-emphasize things like credit score and having a co-signer. Instead, they are now tracking what we expect your earnings to be based on the program you’re enrolled in.

The second way is that when they’re in repayment, if they have lower earnings than expected, or they suffer some type of shock—a recession, a pandemic, all of these things can happen that can lead to students not getting the earnings that they thought they might get—an outcomes-based financing tool provides flexibility for those borrowers. You can say that the outcomes-based financing bends when life bends. It is not that type of rigid repayment that could create a kind of financial albatross for that student.

Q: So, how does this legislation change what can be considered in underwriting? Because my understanding is that currently many lenders believe the outcomes-based factors you mentioned can’t be considered without violating the Equal Credit Opportunity Act, a law that prohibits creditors from discriminating against credit applicants on the basis of group characteristics like race, color, religion, national origin, sex, marital status, age.

A: I should say, the Equal Credit Opportunity Act does not prohibit providers from using outcomes-based financing, and there are lenders that already do this today. But the vast majority of lenders avoid using outcomes data in their underwriting because it subjects them to regulatory risk, which makes them nervous, even if what they’re doing is perfectly legal. So for lenders that offer outcomes-based financing, this bill creates more clarity and assurance that they can use certain outcomes metrics, like completion rates or median earnings, as part of an empirically derived methodology. They’re still subject to the Equal Credit Opportunity Act; this bill simply provides more clarity in how to comply with it. And I think there’s a really good reason for that: Right now there’s a disparate impact in education.

In particular, if you think of some really low-performing or predatory schools—who tends to be the victims of those schools? They tend to be students who come from those [Equal Credit Opportunity Act]–protected classes; just the provision of education itself oftentimes has a disparate impact.

If I’m an outcomes-based financing lender, I don’t want to be lending to students that are attending schools that have really horrible completion rates, because I don’t think that those schools are serving their students. I don’t want to perpetuate that bad business model. But currently there’s a perverse aspect of the Equal Credit Opportunity Act that in theory could actually force the lender to be providing financing to those students and enhance disparate impact.

What this legislation is saying is that you need to allow providers of outcomes-based financing to take into account some of the outcomes metrics to ensure that they are only financing students at schools where they are actually going to serve the students.

Q: So what’s the incentive for lenders in this system of outcomes-based loans?

A: It’s a good question. When JFF has been doing this legislation, the organizations we partner with generally are nonprofit providers with outcomes-based financing. So these are lenders that are not trying to really make a profit; they’re just trying to be sustainable. Sometimes the goal is not even to be sustainable, but rather to simply recycle some portion of the revenue back.

Social Finance is a really good example of this. They offer zero-interest outcomes-based loans for a certain segment of their programs, so they’re not making a profit on that. They’re not even recouping, but nonetheless it can be a better philanthropic approach. Rather than simply providing the service for free [like a scholarship], they’re able to make sure that some recipients of those services pay back and then they can then recycle that money and expand access to even more students than otherwise would be eligible.

For more for-profit options or ones trying to provide some kind of return on capital, I think it’s actually really useful to look at some of the research that came out of Purdue University. Purdue had an income-share agreement program from 2017 to 2022, and they recently did research showing that about two-thirds of the students in their program paid less than they otherwise would have under a comparable fixed-payment loan.

Now that means that one-third of the students ended up paying a little more than they would have under that comparable fixed-payment loan—and that kind of answers your question. Under this type of approach, some students pay more and some students pay less. Which ones pay more and which ones pay less is entirely dependent on their earnings.

It’s less about how they profit from it. You’re just redistributing the repayment away from low-earning students and toward more of the high-earning students.

Q: What are some obstacles to scaling up outcomes-based options for students?

A: Right now there are a lot of regulatory guardrails, which were designed to protect students, that are actually standing in the way of students having these more affordable options.

Imagine that you’re a car manufacturer, and yet you’re subject to all of the rules and regulations for home building. So you’re building a car, but the car has to have an earthquake-resistant foundation. That would be really weird. But it would also not protect consumers, because that’s not a form of consumer protection that makes sense for cars. In fact, they’d be less protected, because it wouldn’t say anything about seat belts, airbags or crumple zones.

The point here is that in that circumstance, the consumer protections are poorly designed for the product, and so therefore you end up with the worst of all outcomes. That’s where we are at with outcomes-based financing. In addition, we recognize that there is risk to some of these as well. It’s possible for a provider to design one that is predatory, and so we also want to make sure that the consumers are protected.

There are a number of changes that can be made to accomplish that. One is adjusting underwriting regulations, as discussed previously. Another is around disclosures.

The federal Truth in Lending Act was really built for fixed-payment loans and just is not well suited for outcomes-based financing. An example is that the act requires disclosure of the loan’s annual percentage rate, or the APR. But the APR of an outcomes-based financing tool can vary widely from student to student, because how much they pay back actually depends on what their future incomes are going to be. So, what we’ve proposed in this bill is amending the Truth in Lending Act to ensure that the outcomes-based loans have more customized or unique disclosure guidelines. They still need to provide standardized and conspicuous disclosures, but they need to do so on outcomes-based financing–specific terms.

Q: Would this legislation also allow traditional lenders to consider some of those forward-looking characteristics? For example, could they take into account the cohort default rate of an institution rather than look at the financial history of an individual and their family?

A: It would not, and that’s because the legislation is specifically designed to only apply to outcomes-based financing, and there’s a reason for that. We didn’t want to be changing the rules of the road for all loans.

Now, what this legislation would do is create space for those students to be served with outcomes-based financing products, which will shift risk away from the student. As to whether it could lead to some other type of legislation for fixed-rate loans, I’m not sure. Maybe if this is successful it could, or maybe we just decide that we’re really happy with them being served by these really student-friendly outcomes-based financing products, and we can just leave it at that.