What if you never had to take out student loans to pay for school? What if, instead of borrowing money at a certain interest rate (and other restrictions), you simply promised a percentage of your future earnings to cover the cost?
If things don't pan out and you don't earn much, well the school "failed" you and they don't get much in return. But if you do well, land a high paying job after graduation, the school could earn a nice reward. Given the correlation to your earnings, this could really help your college return on investment if done right.
That's the premise of a new financial tool colleges are using to help students pay for school - income-share agreements (ISAs). While the tool sounds promising, it's anything but simple. In some cases it can be better that borrowing student loans, but in many cases worse.
Here's what you need to know about ISAs if you're considering it.
What Is An Income Sharing Agreement (ISA)
In an effort to help students reduce or avoid student loans, colleges across the United States are creating ISA programs. These programs work by giving students a certain amount of money towards tuition per school year. After the student graduates and gets a job, a percentage of their income goes toward paying off the ISA.
You might ask, how is this not a loan if students are borrowing money each year? Terminology on ISAs sounds more favorable than it is. First, let's be clear - an ISA is basically a loan. You have to pay it back. If you take an ISA, you are going into debt.
Many ISAs advertise that students do not have to pay interest. This is not the case in practice. Students will usually pay more than the original amount borrowed. Call that difference whatever you like, but it serves the same purpose as interest. Investors who fund ISAs aren’t lending money out of the good of their hearts. They are doing it to make money.
ISAs do have several benefits:
- You only pay when you have income from employment (if you voluntarily leave your employment, the ISA goes on "pause" and resumes when you're working again)
- Most ISAs do have a minimum income requirement, so if you only are working minimum wage, you may not be required to make payments
- If you hit the end of your repayment term and your income was low enough, you could theoretically pay back less than you borrowed - but that would be rare
The Math Of An ISA
Consider an example: A student takes out $10,0000 worth of ISA funding. They land a job with a starting salary of $30,000. The ISA payback is 7% of their income for 10 years. This means $2,100 for each year the student makes $30k. If after four years, the students salary jumps to $34k and then $38k after another four years, they will pay back far more than the amount borrowed. Below is a breakdown of the payback:
- Year 1: $30k @ 7% = $2,100
- Year 2: $30k @ 7% = $2,100
- Year 3: $30k @ 7% = $2,100
- Year 4: $34k @ 7% = $2,380
- Year 5: $34k @ 7% = $2,380
- Year 6: $34k @ 7% = $2,380
- Year 7: $34k @ 7% = $2,380
- Year 8: $38k @ 7% = $2,660
- Year 9: $38k @ 7% = $2,660
- Year 10: $38k @ 7% = $2,660
For a total of $23,800. You might say that is absurd and yes - it is. But know that many ISAs do cap their total payback at 2.5X the loan amount.
In this scenario, the additional $13,800 is basically “interest” and is completely within the 2.5X cap. If your salary rises enough, that 2.5x cap could make you repay $25,000 in total to borrow $10,000. That's effectively a 22.25% APR on your loan. That's expensive.
Most ISA programs will allow students to borrow up to $10,000 per school year. As mentioned, a 2.5X cap is usually the maximum although these amounts can vary.
Compared to a $10,000 student loan at 7% interest paid back over 10 years, total interest is only $3,933. That’s a savings of ($13,800 - $3,933) $9,867 over the above ISA terms. And that 7% interest is definitely within the best student loan rates, for both Federal and private loans.
While the above scenario doesn’t seem like a great deal, there are some students who may benefit from an ISA.
Who May Benefit From ISAs
ISA payback rates and years are determined by each university by college major. Majors with lower starting salaries such as history, English, or social services will have higher payback rates and longer terms. For example, 5% - 7% over 10 years, creating the scenario from the previous section.
Majors that fall into the STEM fields (science, technology, engineering, mathematics) often have higher starting salaries. These majors will have better payback terms, such as 3% for 8 years. That’s a big difference and can actually work out better than student loans.
Using Purdue’s ISA comparison calculator, an “Aeronautic Engineering Technology” major graduating in Dec 2020 will payback on a $10,000 ISA at 3.36% income share over 8 years (96 months).
In this example, the total ISA payback is $16,523. Taking a PLUS loan is $17,311, and the private loan is $19,162. Using the same comparison tool, a history major’s income share will be 4.31% over 112 months (9.33 years). This results in the PLUS loan being slightly more favorable.
Final Thoughts
ISAs aren’t for everyone. It greatly depends on the terms offered by the ISA program. The lower the income share rate and terms, the better the ISA deal. It’s important to calculate out total payback against student loans to get an accurate comparison.
Also, keep in mind that unlike student loans, ISAs are unregulated and may not offer the same advantages as student loans (forbearance, hardship deferments, etc.). For the right terms, ISAs can work. Otherwise, students may want to consider traditional Federal student loans.
