Income collateralized loans: Market and policy explorations

By lending to a borrower who pledges an income contingent repayment stream over a predetermined time period, a creditor may be paid more or less than the amount lent, depending on the income level attained by the borrower. A normative model of individual choice for loan contracts illustrates the ideal use of percentage of income loans as part of an overall financing strategy. The model shows that for some preferences (risk aversion levels) and beliefs about income, Pareto efficient contracts could consist of: (1) an all fixed repayment stream (all debt), (2) an all variable repayment stream (all percentage of income), or (3) a combination of fixed and variable payments.;Just as normative explorations of the corporate borrowing decision shed light on optimal debt equity ratios, this research outlines a vocabulary and framework for viewing the individual borrowing decision when both debt and percentage of income financing are available. Percentage of income financing for an individual is shown to be roughly analogous to equity financing for a company. Just as in the corporate case, taxes and agency costs may limit the attractiveness of debt financing. However, unlike in the corporate case, the optimal use of percentage of income financing is determined largely be the differential beliefs about future income and the differential risk tolerances between the lender and borrower.;The absence of this new funding mechanism in today's marketplace is shown to be a direct result of three major government policy areas: contract legal risk, fiscal policy and bankruptcy law. The ill effects of each are described and remedies are suggested. Toward overcoming a major justification to the current bankruptcy law, this research introduces a new contracting methodology which allows a borrower to use future income as collateral in loan agreements. Using such contracts would facilitate the funding markets that correctly price the value of educational investments. These markets would then create the environment in which desirable new financing arrangements such as the percentage of income loan could become a reality.