Student-loan twist: you owe if you earn

Like most college students today, Parisa Baharian relies heavily on financial aid to cover her costs at the University of California, San Diego. So when the school ran out of federally subsidized loans last fall, the political science major sought out alternative sources.

Ms. Baharian rejected the idea of taking out a bank loan, and decided she was too busy for a part-time job. "Credit-card debt is the most scary of all," she says, rounding off the list of nixed possibilities.

She finally settled on a new type of aid program that gives new meaning to the axiom: "College is a good investment."

Instead of a loan, the college senior secured a $2,500 "human capital investment" from the nonprofit Robertson Education Empowerment Foundation (REEF), founded by UCSD alumni and Internet entrepreneur Michael Robertson.

In return, Baharian agreed to pay 0.76 percent of her salary to REEF for the next 15 years - even if that figure turns out to be vastly more than she received.

Baharian, who plans to be a lawyer, estimates she will pay back about $5,000 instead of the initial investment of $2,500.

"Would I recommend this in place of funding that the school gives you? I would say no," she says. "But when it comes to banks and credit-card debt, this is a good way to go. I've basically avoided credit-card debt by going through REEF."

Baharian also says she agreed to the deal because REEF will reinvest her payments to provide scholarships for other needy UCSD students. "I wouldn't have done it otherwise," she says.

While some critics have described the contracts as a type of indentured servitude for students, others say the financing model is a better alternative to the huge debt loads that most students carry with them after school.

Under the REEF program - which was modeled on the New York for-profit investment firm MyRichUncle that launched in 2001 - students can receive up to $7,000 a year for which they pay a fixed rate of between 0.2 percent to 4 percent of their future earnings over a set period of time. The interest-free repayments rise or fall depending on the person's salary. At the end of contract, the obligation is over, regardless of whether the final total is more or less than the original investment.

Most loans don't take into account a person's economic situation at any given time, says MyRichUncle co-founder Raza Khan. The fixed repayment rates, by contrast, always reflect a borrower's ability to pay, dramatically reducing the risk of default, he says. And if a borrower falls below the poverty level, arrangements to suspend payments for a period of time can be made.

Many students now leave college with huge debts, Mr. Khan explains, including about $7,500 on credit cards that charge 22 percent interest. "When students first leave school, that debt is actually a very high percentage of their income," says Mr. Khan, whose web-based firm matches investors ("rich uncles") with needy students.

"It's only toward the end of the repayment schedule that the debt becomes a smaller and smaller percentage of the gross income," Khan continues. "Whereas, we remain the same percent of income throughout the life of the agreement."

Repayment rates mirror those of REEF. They are determined by a number of factors, including a student's age, academic major, test scores, former work experience, and income-growth potential.

But one financial-aid expert says plenty of less expensive alternatives exist.

"Borrowers who use that service will be worse off than if they just got a traditional student loan, or even a private student loan," says Kenneth Redd, director of research and policy analysis for the National Association of Student Financial Aid Administrators.

The binding contracts don't let students pay off the loan early as with traditional financial aid, Mr. Redd says. "We've done the math. You pay at least twice as much."

Federally subsidized student loans currently have interest rates of 3.46 percent, the lowest at any time. Some also have income-contingent options, which let graduates increase their repayments gradually as their financial situation improves. Even private bank loans currently have competitive interest rates that hover around 4.5 percent to 6.5 percent.

Redd suggests that educational investments such as MyRichUncle "take advantage of students who are not knowledgeable about traditional financial aid," or who are "desperate to just get any funds to stay in college."

Unfortunately, this desperation is an increasing problem as college costs skyrocket and federal student aid programs stagnate.

The funding gap hits freshman and sophomores especially hard, explains Jerry Ditto, a financial-aid counselor at Western Michigan University in Kalamazoo. Federal loan limits for underclassmen are $2,625 per year. "That doesn't even pay tuition at a low-cost institution," Mr. Ditto says.

Private lenders and banks have stepped in to fill the void in recent years with a host of alternative loans that mirror federal loans, including deferred repayment plans. "Over the past three or four years, our loan volume in those types of loan programs has tripled," Ditto says. "The loans work very well."

But organizers of MyRichUncle and REEF - the only two known groups currently offering such investment plans - counter that their financing model is competitive, and only seeks to fill the gap where traditional loans and grants leave off.

REEF founder Mr. Robertson contends the investments offer more peace of mind than private bank loans, which come with interest rates that could rise dramatically in the future. "There is a lot of uncertainty in the student loans because they're adjustable," says Robertson, also founder of the Internet music site www.MP3.com. "You could end up paying more, you could end up paying less."

But he also believes that both the investment and traditional loan models are not so different. "They're not giving out the money purely for altruistic reasons," Robertson says of the traditional loans. "They want a return on their money, too."

Under one hypothetical example given by MyRichUncle, an MBA student receives a $10,000 investment and agrees to pay 2 percent of his or her gross income for 10 years.

If the student makes $50,000 in the first year and the salary grows by 3.5 percent each year, the graduate would have to pay the investor a total of $11,731 by the end of the payment period. If the MBA student made $400,000 in the first year and saw the salary grow 3.5 percent each year, the payback would be $93,851. By contrast, a 9 percent private loan on that $10,000 pays out $15,201.

Ideally, Khan and others say, the investment model could unleash billions of dollars in capital that now is tied up in institutions rather than individuals. "One of the things that our for-profit investors realize is that you're a lot better off investing in people than companies," says Khan. "Most of the value created in America is not from machines and technology, it's from people. Companies can afford to go bankrupt, people can't."

While only about 65 students received loans in 2001 through MyRichUncle - and a dozen more through REEF last fall - both organizations say there is "tremendous interest" in the programs.

"We don't just see this becoming a significant player in the higher education market, we think this entire concept of investing in individuals is going to be an integral part of the financial landscape," says Khan.

But the profit-driven mechanism may still be a tough sell to some students seeking aid.

USCD student Baharian views the additional repayment beyond the $2,500 as a charitable contribution, although it is not tax deductible. "I've chosen REEF as my charity, so to speak. That's the way I have to justify it. Otherwise, what's the point of basically binding yourself into a 15-year commitment?"

For investors, a chance to put some stock in 'human capital'

With the stock market hitting new lows, many investors may seek alternative financial products that aren't subject to the whims of Wall Street.

Raza Khan, cofounder of the online investment firm MyRichUncle, says they should look no further than their local college. Students, he says, are an untapped investment resource promising strong, steady returns.

"So far, they're a safer investment than stocks," notes Mr. Khan, whose two-year-old company lets individuals "invest" in college students in return for a portion of their future earnings over a fixed time period.

While the concept of investing in individuals has been around for a while, MyRichUncle is the only for-profit firm currently offering "human-capital investments" that aim to serve two distinct groups: students seeking funds and investors seeking returns.

So how much return can a for-profit education investor expect to reap? One could potentially strike it rich with a philosophy major who becomes the next Bill Gates. Or lose money on a law graduate who decides to chuck the courtroom for a classroom. But Khan says "most students earn a predictable income, and we account for that in the rates that we provide for them." MyRichUncle sets the rate after examining a student's grades, courses, and career goals, among other factors.

Khan says investing in people rather than companies makes senses. "If you look at labor, on average it continues to appreciate in value," he explains. Essentially, what the investor gets is a "long-dated product" that guarantees a stable return over a 10- or 15-year period, Khan says, noting his firm spends "a lot of time" analyzing income potential in ways that promote accuracy.

Some experts, however, warn that the innovative investment has its risks, not the least of which is the ability to enforce the multiyear contracts.

"The issue of contract enforceability will only be determined with certainty when one of these contacts is challenged in court and a favorable ruling is obtained, or when human-capital contracts are recognized in every state or at the federal level," writes business scholar Miguel Palacios in an analysis of the concept for the Cato Institute, a libertarian think tank.

While he favors the concept, Mr. Palacios says investors face another key challenge: Students will have the incentive to hide or postpone earnings, he says.

"The growth of human-capital contracts will depend on the ability of those who design the instruments to accurately determine a student's potential income and the capacity to collect payments," writes Palacios, a fellow at the University of Virginia's business school.

Khan, of course, is bullish about the program's prospects. It can be tailored in many ways, he says, including for professional investment firms, nonprofit alumni organizations, or as part of a pension fund. Investors can select individual students, or participate in funds directed at specific types of student majors.

"We are essentially creating the entire marketplace by which one can invest in students," Khan says.

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