What are income share agreements (ISAs), and how are they different from student loans?
In simple terms, an income share agreement is an obligation, but not a loan, where the investor receives a fraction of income from a student during the payment term. The investment is a hybrid investment, in the sense that investors do get upside returns for a range of income levels.
ISA terms can vary significantly across programs and investors, but there are some common elements. The following are some typical terms in ISAs:
Income share rate: The income share rate is the proportion of income that is owed. This is usually described in percentage points. So, if an income share agreement has 2% income share rate, and the student graduates with a $50,000 annual salary, their monthly payment is 2%*$50,000/12 = $83.
Payment Term: The maximum number of monthly payments a student makes. This number is always fixed for an ISA. More recent contracts have tended to have payment terms between 24 months to 60 months.
Salary Floor: The salary floor is the income threshold below which ISA payments are deferred or forgiven. If an ISA contract has an annualized income floor of $40,000, then the ISA payments for a student making less than $40,000/12 = $3,333 are deferred, if the contract is in deferral period, or forgiven, if the deferral months are exhausted.
Deferral period: Payments on ISAs can be deferred if the student’s salary is below the salary floor. MentorWorks ISAs have a 24 month deferral period.
Payment Cap: The payment cap is the maximum amount that the student pays on the contract. If students find a very high paying job, the payment cap will protect them from overpaying. This number is fixed and will not change throughout the payment term, regardless of student income.
MentorWorks ISA contracts often have early payment or pre-payment amounts for each year, which are lower than the payment cap and allow students to complete their obligation earlier if they choose to.
The payment cap and pre-payment amounts serve a few important purposes.
– They lower student cost, particularly for those students who anticipate doing well. For the investor, this reduces “adverse selection” – that is, the concern that students will choose the ISA program if they anticipate having lower income. By limiting student cost, the payment cap and pre-payment options make it cheaper for students who anticipate doing well to select ISAs.
In our experience, students who anticipate doing well in particular care about the payment cap, pre-payment options, and the salary floor. Interestingly, students with a higher likelihood of paying back are also those that focus on pre-payment and payment cap aspects!
– It reduces any potential “optical” and legal liabilities. Beyond the economic reason and the fact that it is student-centric, ISAs which are less onerous on students in terms of payment cap and pre-payment options also have better optics. Such ISAs also have a lower risk of being categorized as a loan.
How are ISAs different from loans?
Two key features of ISAs distinguish them from loans:
- Students pay a percentage of their income, and not a fixed amount like a loan.
For students, this is a powerful value proposition, since they are no longer expecting to be burdened by debt that they may not be able to afford. The salary floor allows students to get relief during periods of low income and financial distress. On the other hand, if they do well, they can finish their obligations early and limit how much they pay back.
For investors, there is an upside component to investing, which depends a lot on the educational program that students are financing through ISAs. As a result, the quality of the educational program, school, and field of study are some of the key characteristics for an ISA investor to consider.
- Payments are capped and have fixed payment terms for students.
ISA payments are capped and fixed payment terms. This is valuable for students as it creates a predictability around their obligations.
In a student loan, one often overlooked issue is that if minimum payments are not made on time, interest accrues and capitalizes. That is, interest adds on to the principal, and students end up paying interest not only on the original principal, but also the added interest. There is no limit to how much students can end up paying. Moreover, the maturity of a loan can be deferred, in many cases indefinitely, until the students satisfy their loans’ return requirements.
The practical effect of this is to increase the effective interest rate. As an example, a college student in their senior year who takes out a PLUS loan (actually their parents sign for this), theoretically has a 7.6% interest rate. However, if they do not pay interest during their period of education, the effective interest rate on this loan, including the effect of fees and accrued interest is close to 10%. For a junior year student, this implied interest rate can be as high as 12%.
Over the last two years, we have invested in ISAs and have fielded many questions about this model from investors, schools, and students. Here are some frequently asked questions:
Isn’t this indentured servitude?
This question came up earlier in our life as an ISA provider, but has been less frequent recently. However, it is important to address this.
We view both loans and ISAs as income sharing programs. After all, with a loan, you are still sharing your income with the lender, but using a different formula to calculate payments. In this sense, loans and ISAs are equivalent.
The income share rate only sets the payment formula, but does not obligate the student to choose any specific career path. They have complete freedom to choose their occupation and employment terms. The payment terms remain the same regardless of the occupation they choose. So the indentured servitude argument does not apply here.
ISAs are more flexible to the income situation that a student is in, precisely because it ties student payments to their income. A well-designed ISA provides students the opportunity to reduce the risk and cost of defaulting and provide a payment stream that is affordable for the student. This is similar to the income based repayment option for federal loans.
What factors are considered in determining ISA terms?
Factors considered in determining income share rate relate to the future career potential of education program. ISA returns, not surprisingly, are sensitive to income levels. So prior program outcomes data are often used to price ISAs for specific educational programs.
Some things that we have considered in pricing ISAs are: school, major, work experience including internships, academic performance, and current or past full-time income.
In our pricing models, we account for average outcomes, default expectations, and, very importantly, the variance of income around the mean. Since ISAs are capped outcome investments, it is particularly important to account for the distribution of income expectations around the mean.
What if students default on payments?
The term default is used in a different manner for ISAs than for loans. As long as students are current on payments or submit documents for mitigating circumstances, they are not in default. ISA defaults include non-payment conditional on sufficient income or on lack of providing proof of income falling below the salary floor.
The MentorWorks model actively supports student in finding employment opportunities as a way of managing risk. This is our value-added to both students and to investors. By connecting students to a network of professionals and to employers, our model can reduce investor risk and lower student costs. The reason this is true is because the active ISA model is no longer a zero sum game. The value added through higher employment likelihood is shared between the students and the investor.