Can income sharing plans replace student loans?
The rising cost of college tuition has become an increasingly daunting obstacle for clients. However, a decades-old alternative may be useful for students looking to mitigate the investment needed to procure a college education.
An income share agreement allows the student to enter into an agreement with their school, or some other institution, that obligates the student to pay a percentage of future earnings over a period of time. Instead of taking out a loan, the student funds their education by tapping their own intellectual equity.
First proposed in 1955 by American economist Milton Friedman, the upside of ISAs, at least in theory, is that as with other types of equity financing, the student can ensure that payments are based on a reasonably manageable percentage of their income. This helps the student stay ahead of payments and avoid reaching a point where they can’t afford to meet the monthly loan obligations.
Friedman proposed “buying shares” in individuals as a means to finance higher education in the essay titled, “The Role of Government in Education.” Yale not so successfully experimented with ISAs in the ‘70s, and states, universities and private lenders have more recently begun exploring ways in which ISAs can be used to help finance higher education.
By agreeing to pay a fixed percentage of their income, students can ensure their obligations will never exceed some pre-defined, percentage-based threshold of their total future income. But lest ISAs be considered a workaround for traditional forms of debt, planners must make a thorough study of how they compare to more by-the-book student loans.
Let’s take this example. Assume John’s university agrees to provide some funding in exchange for 5% of his future income for 10 years. With a traditional private loan, John may owe up to 100% or more if his income is low enough. But with an ISA, he can rest assured that he will never owe more than 5%. In the event that he struggles to find a job after graduation and is underemployed earning $25,000 per year, John is only obligated to repay $1,250 in his first year after graduation — and that year will count as a full year’s worth of his repayments, meaning John will be 1/10 of the way toward meeting his obligation.
One key way in which many ISAs differ from federal loans is that students may be charged different rates based on various factors, including their field of study. For example, two students at Purdue University — which, via the Purdue Research Foundation, has been one of the pioneers in developing modern ISAs — both expecting to graduate in December 2019 might pay the following rates in exchange for $1,000 to put toward tuition:
- English major: 0.45% of their future income for 116 months
- Aerospace engineer: 0.27% of their future income for 92 months
According to Purdue’s ISA comparison tool, an English major may expect to earn about $31,000 upon graduation, whereas an aerospace engineer may expect to earn about $62,000. Not surprisingly, aerospace engineers can therefore receive ISA rates close to half of what English majors must pay, as it still nets roughly the same amount to the lender offering the ISA.
Note that because the Purdue program is so well-established, its numbers are used throughout this analysis. Of course these values can change over time, and other programs are free to modify the terms of their agreements in ways that may influence which option provides the best outcome for students. Unlike federal loans, ISAs are largely unregulated, which may be good or bad depending on a planner’s perspective, but it is important to understand that there may be more variation from one offering to the next than is common among other financial products.
The chart below provides a sense of how much various majors would pay under an ISA by field of study, based on Purdue’s ISA program. In each case the rates and terms of future income sharing required to fund $1,000 in expenses are provided:
As the chart indicates, students majoring in the hard sciences and more quantitative, applied fields are able to finance their education at the lowest income share rates, whereas those studying the humanities and other lower-paying fields must share a greater proportion of income.
An interesting side note, Financial counseling and Planning comes in near the middle of the considered majors. Because planning and counseling are both fairly different in terms of their expected earning trajectories after graduation, this could be a case where this averaged rate is more attractive for aspiring counselors, and less attractive for aspiring planners.
Continuing the prior example, a sophomore aerospace engineer at Purdue may actually need to pay 0.40% to borrow $1,000, whereas juniors and seniors may owe 0.30% and 0.27%, respectively, with all values based on a 92-month repayment period. If we assume a student needs to borrow $10,000 per year for their final three years of their education, they would owe a total of 9.7% of their income upon graduation (0.4*10+0.3*10+0.27*10).
Notably, most programs also have a payment cap, typically up to 2.5X of the initial amount paid toward education. Purdue happens to cap payments right at 2.5X. This cap is important as a means of placing a reasonable limit on how much someone would need to pay in the event they did end up earning a lot after graduation, and also to avoid discouraging participation rates from those who feel they may be higher earners in the future.
Caps also help ensure that if the aerospace engineer ends up owing 10% of their income after taking out various ISAs throughout their education, they wouldn’t actually be stuck with a $10 million repayment obligation in the event they made $100 million with a wildly successful startup. Instead they could buy themselves out of the ISA by paying the difference between 2.5X the amount dispersed to them plus fees, and any income sharing payments they had already made.
For example, if John borrowed a total of $10,000 in the last year of his education and wanted to buy himself out during his first year of repayment, he would need to repay a total of $25,000. Indeed, paying $15,000 in interest on a loan of $25,000 would be roughly akin to paying an annual interest rate of 150%. This illustrates a key hazard of ISAs: Buying oneself out still can end up being an expensive project.
In fact, assuming an ISA was taken out in one’s last year of studies, such 2.5X buyouts could be akin to an effective annual interest rate ranging anywhere from 9.6% to 150%, depending on when the buyout occurred. But this may be a potential upper bound cost that is tolerable; after all it only applies when the individual is having significant career upside.
TERMS AND PROVISIONS
While ISAs can vary substantially from one provider to the next, examining specific terms within Purdue’s ISA can provide a general understanding of how ISAs might address some common questions.
Can individuals just sign up for an ISA in hopes of never working and never repaying anything? No, or at least not over the initially defined term. Individuals cannot get out of their ISA obligation simply by relaxing and taking time out of the workforce. Various deferment triggers exist which may extend one’s payment.
Within Purdue’s agreement, the clock does not start until after an initial six-month deferment period. After this period individuals have to be either employed full-time — i.e., an average of 35 hours per week or more — employed part-time and earning more than $20,000 per year, or unemployed and actively seeking employment in order for their clock to keep ticking.
Those who take time off out of the workforce — e.g., to care for a child, illness, etc. — do not have to make any payments, but their term is extended as well. However, Purdue’s ISA appears to suggest that the maximum term of extension is 60 months, which would seem to imply that similarly structured ISAs could become very attractive for individuals who wish or plan to spend significant time out of the workforce raising children.
Purdue’s ISA does eliminate all monthly payment obligations for anyone working full-time and earning less than $20,000, while still allowing them to accumulate credit for those months toward fulfilling their ISA. When combined with crediting time toward unemployed grads who are actively seeking employment, agreements structured similar to the Purdue ISA do provide a nice cushion in the event that someone genuinely falls on hard times.
Notably, under the Purdue ISA $20,000 is a hard breakpoint, which can create some perverse incentives. If a student has participated in ISAs up to the point of owing 15% of their income after graduation — the maximum Purdue ISAs permit — the student would owe $0 if their income were $19,999, but $3,000 if their income were $20,000.
This effectively creates an incredibly high marginal tax rate for some low-income individuals, and is yet another example of the so-called poverty traps that can result in marginal tax rates of 80% or higher for low-income individuals.
Although Purdue’s definition of earned income appears dated — presumably their reference to summing lines 7 and 12 on one’s Form 1040 refers to the 2017 version of Form 1040 before it was revised for 2018 — the income the school is interested in appears to be only W-2 wages and Schedule C income of the individual who signed the ISA agreement. That means a spouse’s wages don’t count, nor would capital gains, pass-through or other passive business income reported on Schedule E.
Note that while it may not be feasible for many individuals who lack some other form of support, someone earning up to $38,999 — or $57,999 with a qualified 403(b)/457(b) combination — may want to consider maximizing their 401(k) contribution to drop their W-2 income to $19,999, and therefore avoid what would have been a maximum of roughly $5,850 or $8,700 in ISA obligations, assuming a 15% income share. Meanwhile they’d still earning a full year’s worth of credit. Of course that may be difficult to accomplish on a single income, but such strategies might work well for dual-income households.
From a planning perspective it’s not clear how ISA funds will be taxed. While the Purdue contract notes this uncertainty, the agreement suggests that individuals who pay back less than they initially received will need to treat the difference as ordinary income at the end of the agreement period. This differs substantially from the tax-free treatment of federal loans forgiven under programs such as public service loan forgiveness (PSLF) and could be a nasty surprise for individuals with little cash flow to fund a potentially significant tax liability at the end of their agreement.
‘DIRECT’ FEDERAL LOANS
The most common type of fixed-rate loans offered by the U.S. Department of Education are those dispersed via the so-called Direct Loan Program. These loans are available as either Direct Subsidized — i.e., interest accrued while in school or in deferment is paid by the government — or Direct Unsubsidized, whereby interest accrued is paid by the individual, with current interest rates from July 1, 2018 to July 1, 2019 of 5.05% for undergraduate and 6.60% for graduate students for both subsidized and unsubsidized loans. Standard repayment schedules for direct loans are 10 years.
One benefit of direct federal loans is that students generally have access to various income-driven repayment plans, which can reduce payments but also increase the repayment term. Effectively, this provides a similar type of protection to borrowers that ISAs provide.
While income-driven repayment rules can vary by program, borrowers generally have the right to pay no more than 10% of their discretionary income — defined as their income minus 150% of the poverty level threshold in that area and adjusted for their family size, which amounts to roughly $18,735 for a single individual across all 48 contiguous U.S. states and Washington.
This amount is roughly akin to the $20,000 for a single individual under the Purdue ISA, but is substantially more generous for larger families, providing a floor of $45,255 for a household of five individuals. Additionally, the income-driven repayment rules are not subject to the same hard breakpoint problems that the ISAs considered above have, as individuals are only required to pay 10% of the excess of their respective threshold.
In the event a borrower reduces their payment as part of an income-driven repayment plan, the borrower will begin paying less than the full amount needed to exhaust the loan in 10 years, and the term will accordingly be increased until the loan is eliminated, or the individual has made qualified payments long enough to earn federal loan forgiveness — often 20 or 25 years, depending on the loan forgiveness program, but possibly as early as 10 years in cases of public service loan forgiveness.
If payments are not sufficient to cover the interest expense on a loan, borrowers can go into negative amortization, in which unpaid interest is added to the loan balance.
In other words, a household of one effectively has an income floor of $18,735 that they must exceed before owing anything on their qualified federal loans. And because the income floor can increase substantially with family size, there’s a possibility of shielding more income from repayment requirements under direct federal loans. That said, direct loans consider a spouse’s income for income-driven repayment options, whereas ISAs do not, so the impact could go either direction depending on family earning dynamics.
If the purpose of choosing an ISA is solely cash flow protection in low earning years, federal student loans generally are equal, if not superior, to ISAs.
The caveat to any income-driven repayment strategies is that unless one hopes to take advantage of a loan forgiveness program by making underpayments that are capped due to low income continuously for 20 to 25 years, the can is merely kicked down the road, with the loans coming due, with interest, at a later date.
At the same time, while repayment caps with federal loans can extend repayment terms, there are loan forgiveness programs available. This means it’s actually possible that a federal loan could both be cheaper and provide superior downside protection. But in order to know for sure, it is helpful to do a direct comparison of the cash flows, and see which provides the better outcome under various circumstances.
ISAs VS. FEDERAL LOANS
For the sake of comparison, let’s consider an English major and an aerospace engineer who each need $26,500 to fund their education. To simplify, assume they need all of these funds in their final semester. Further, assume they are single and earn a constant, inflation-adjusted amount per year after graduation.
At current federal interest rates the borrower’s monthly repayment amount on a 10-year schedule would be $281. However, at $30,000 of pay, income-driven repayment would initially cap that monthly payment at $94, given current federal poverty level thresholds used to calculate the 10%-of-discretionary-income repayment cap.
By contrast, for the English major under the ISA, roughly 11.925% of their income would need to be given up for 116 months to receive $26,500 in funding, which would result in an initial ISA obligation of $298 per month on their $30,000 of income.
If discount rates of 3%, 8% and 12% are used to compare the two cash flow streams, the borrower comes out ahead in all scenarios by financing their education with federal loans instead of the ISA, due primarily to the more generous income-driven repayment protections that apply for such loans.
However, the total cost of the loan may not be the only factor that prospective students must consider when choosing between a federal loan and an ISA. Realistically, students would also be interested in the burden each strategy would place on their eventual cash flow.
Nonetheless, it would be fair to say that ISAs still place a larger burden on one’s cash flows when compared to a traditional federal loan. To the extent that the ISA ends up as the lower-cost option, it’s only because of ISA relief in later years — i.e., after the ISA term ends, but while the federal loan payments may have had to continue — and not in the early years when the ISA still has a higher cash flow burden.
Based on the comparisons, and assuming that one is comparing federal loans to an ISA that is similar in nature to the Purdue ISA, it seems safe to say that federal loans should generally be preferred to ISAs.
There may be some niche cases in which students may want to consider ISAs first — e.g., where individuals know ahead of time they will not be able to achieve even the average earnings in their field of study, or perhaps in cases such as an engineer who would like to take 10 to 15 years out of the workforce to raise children. But generally speaking, the flexible features built into federal loans provide equal, if not superior, outcomes in terms of both overall repayment and cash flow protection.
However, federal loans may often fall short of what a student needs to fully fund their education, and this is particularly true for students attending more expensive private institutions. As a result it may be best to think of ISAs not as a replacement for traditional federal loans, but as a replacement for their more expensive and less flexible supplemental funding sources, such as private student loans.
ISA VS. PRIVATE
For the purposes of comparing ISAs to private loans, the same framework is used, with the exception that a private student loan — with an 8% fixed interest rate and no flexible payment provisions — replaces the federal loan.
When comparing overall financial burdens, the ISA option is no longer a clear loss for our English major across all initial income levels. The same $26,500 tuition funding level is assumed for consistency’s sake, although this may or may not reflect a typical funding need for supplemental funds based on an individual’s circumstances.
In this case, our English major is better off with an ISA if their initial income level ends up being less than roughly $30,000. Indeed, there is no longer any potential benefit of loan forgiveness for lower-income individuals when using private student loans. At income levels below $16,000, our English major comes out roughly $23,000 to $33,000 ahead with the ISA in terms of NPV, depending on what discount rate is used.
At the same time, for incomes above $30,000 our English major still quickly comes out far behind with the ISA, given how much cheaper even an 8% interest rate is when compared to the effective interest rate built into an ISA structure — whereby the lender takes an ever-higher percentage of ever-higher income. If our English major ends up changing fields or just securing a very high paying entry-level job for English majors of $70,000, they would end up somewhere between $32,000 and $48,000 worse off in NPV terms, depending on the discount rate used.
Of course, as was the case before, NPV differences only tell part of the story. When we examine the differences in cash flow burden between ISAs that have income-driven protections built in, and private loans that do not have income-driven protections, we can quickly see that ISAs provide some real relief in terms of potential cash flow burdens at least at lower income levels. At incomes below $20,000 the English major pays nothing toward their ISA, whereas private loan burdens could claim 30% or more of their cash flow.
And despite the relatively high 12%-of-income burden the English major incurs immediately at $20,000, it isn’t until reaching initial income levels of roughly $30,000 that a private loan burden would reach levels roughly describable as low. Of course, beyond the roughly $30,000 income level the overall cash flow burden of private loans is substantially lower than paying a percentage of income on ever-higher income levels, and the burden of private loans continues to decline as income increases.
One factor not captured here is the potential taxation of ISA funds. As discussed in the ISA overview above, how ISAs are eventually treated from a tax perspective, if/when forgiveness ultimately comes into play, would be a significant factor worth considering.
WHEN ISAS MATTER
Based on the comparisons, using an ISA is virtually never superior to taking out federal student loans. The protections of federal loan programs, through various income-driven repayment plan options, provide more generous protection than ISAs for those who don’t experience strong earnings after college. And the ISA is simply more expensive for those who do experience superior earnings, given the percentage-of-income formula of ISAs.
By contrast, the decision of whether to use an ISA in lieu of a private loan is less clear. All else being equal, the more risk-averse an individual is, the more positive ISAs will look compared to private loans, as ISAs are a means of reducing downside risk of low income by trading off some upside potential — i.e., more payments for the ISA if income ends out being above-average after college.
There’s one clear case to make for using ISAs: when an individual can engage in adverse selection for the ISA lender, effectively gaming the system. At least with respect to the Purdue agreement, the clearest ISA beneficiary seems to be someone going to college who plans to be a stay-at-home parent thereafter.
Counterparties in an ISA would never be privy to this private knowledge. Of course this type of adverse selection also threatens the viability of ISAs over all. Nonetheless, whether ISAs are viable in the long run doesn’t make much difference to someone with access via such means today, and those who want to stay home as a parent may be able to grab some college funding they’ll never need to repay.
Students may also wish to consider what their own attributes suggest about what their personal ROI from attending college may be. As Bryan Caplan highlights in his book “The Case Against Education,” college ROIs vary substantially by student quality.
Caplan separates students into quality categories as follows: excellent (a student with the typical traits of an individual who completes a master’s degree); good (a student with traits typical of an individual who completes a bachelor’s degree); fair (a student with traits typical of an individual who completes high school); and poor (a student with traits typical of an individual who does not complete high school).
“Traits in this case could largely be boiled down to intelligence and work ethic. Caplan estimates that an excellent student would be at roughly the 82nd percentile of cognitive ability, whereas a poor-quality student would be about the 24th percentile.
As Caplan explains: "Zero and negative returns don’t mean fine arts degrees are worthless in the labor market. A fine art degree raises expected income by over 20%. What zero and negative returns mean, rather, is that capturing that raise is more trouble for Fair and Poor Students than it’s worth."
This can be a difficult topic to be honest about, but the reality is that student quality is going to influence how realistic it is for a given individual to achieve average outcomes for an individual majoring in their discipline at a particular school. Individuals who are above average relative to their peers are more likely to experience better financial outcomes.
As a result, and all else being equal, higher quality students should be more inclined to pursue traditional debt financing, rather than give up a future percentage of their likely-to-be-above-average income by going the ISA route. Of course ISAs could also start pricing based on GPA or other quantifiable factors such as standardized test scores, which may reduce the potential returns to adverse selection.
Students with nontraditional career options may also want to give ISAs particular consideration. For instance, a student planning to join a family real estate business after graduation may be able to structure their compensation in a manner advantageous for the purposes of reporting income — or rather, not reporting income as earned income — within the terms of an ISA. For example, they could participate in the real estate income as rental income via Schedule E, which isn’t part of the ISA income calculation.
Another consideration that will increasingly arise: discrepancies between costs by major. Generally speaking, freshmen and those who have not declared a major are excluded from ISA programs, and it’s not clear how all programs will choose to handle dual majors. Presuming the student can pull it off, dual-majoring in, say, psychology (0.45% share per $1,000 over 116 months) and applied statistics (0.30% share per $1,000 over 96 months) could be worthwhile for a student who can then get ISA funding based on statistics, even though their true interest and career aspiration resides in psychology.
And as should always be the case, reading the fine print on these ISAs is tremendously important. With more universities and private ISA providers rolling out their own programs, individuals will need to pay careful attention to the specific terms of that agreement they’re entering.
Ultimately it’s too early to say what type of influence ISAs will have on college funding in the long run. They clearly have garnered a lot of interest, and many people seem to intuitively feel that ISAs have better characteristics when compared to traditional debt financing. But this is less clear when we actually dig into the details of such agreements.