The Benefits of Income Share Agreements
In my previous post, I outlined the features of an income share agreement. Today, I will show how income share agreements have better structural incentives, enable price discovery and reduce the student’s risk better than traditional loans.
The primary benefit of an income share agreement, in education financing, is that the incentives of the investor are aligned with that of the student. If the student earns a higher income, then the investor earns a higher return on their initial investment. In an ideal world, this would lead the investor, whether it be a pure investor-type, mentor, university, or coding school to do everything possible to ensure the success of the student. Compared to the current state of education finance, this is a breath of fresh air.
Today, most students take out loans in order to cover the costs of attending university. These costs can include tuition, fees, health insurance, room and board. The loans are provided by the federal government or a private lender, and they pay the university in full at the beginning of each semester. In this situation, what are the incentives as they relate to a student’s future income?
From the perspective of the university, there is no long-term, direct financial incentive - they have already been paid in full by the lenders. The university might still have some incentive to work for the student in the form of maintaining their public reputation, their accreditation and their national ranking, but it is weak. How much of that work actually contributes to an individual student’s future income? It is not clear and we can’t be sure that it is correlated at all with a student’s income. The university has no direct incentive to care about the student’s future income. What about the lender?
The lender does care to some extent about the student’s future income, but only to the extent that it results in accurate, on-time payments for the term of the obligation. If you can make the loan payments, the lender does not care if you could make more money. Additionally, if a student falls under hard times and at some point fails to payback their loan obligation, it cannot be discharged in bankruptcy.
With an income share agreement, the “lender” becomes an investor. They make more money as the student’s income grows. A university or school reliant on returns from income share agreements for revenue would optimize their operations around income growth for their students.
Because of these incentives, income share agreements are not priced purely on the students ability to pay but also include a prediction of what the students future income will be. This leads to what is known as price discovery, which has benefits for students and society.
The incentive to accurately predict the students future income leads to price discovery. Think of the process of price discovery as a negotiation. In a negotiation, let’s say over the selling price of a house, the seller might initially ask for $200,000. The buyer, who doesn’t like the carpet and thinks the cabinets need to be replaced might initially bid $180,000. At this point there is no agreement and we have not “discovered” the true price of the house. But after some back and forth, and maybe some competing bids, the buyer and the seller finally agree to a selling price of $190,000. The market has “discovered” the price of the house. This price theoretically incorporates all the relevant factors: interest rates, expected inflation, future resale value and each participant’s preferences, among others. To summarize, price discovery is the process by which two parties, in our case a student and an investor, agree on the price of an asset, or contract, and complete a transaction.
The use of an income share agreement would follow a similar process. Pricing an income share agreement would require investors to accurately predict a student’s future income. They might incorporate academic information such as school, major choice and GPA. Any information that might contain some predictive value could be incorporated into a model that attempts to predict future income. In a sophisticated market, there would be pricing differentiation among students with different characteristics. A chemical engineering major with a 4.0 GPA should be able to obtain a lower income-share rate than an English major with a 2.0 GPA, holding everything else equal, if it is expected that the chemical engineering major would earn a higher income on average. This is the case with Purdue’s Back a Boiler program. At Purdue, the income share for a chemical engineering major is 3.04%, and for an English major it is 4.27%.
That’s nice (or is it?1). But how is that a benefit? The benefit is that now student’s can take advantage of the information being conveyed here. The “market” is telling the student that they will make more money if they are a chemical engineering major. They might have already known that, but the consequences of that fact may be difficult to understand. In the case of an income share agreement, the consequences are explicit.
Income share agreements can also function as an insurance policy for the student. When their income decreases, the amount of income that they are required to pay also decreases. If a student falls on hard times, their payment obligations change to accommodate those hard times. For example, if a student is injured and has to take unpaid leave from work to recover from their injury, they do not owe anything to the investor. Compared to traditional loans, this an improvement. While some loans have deferment clauses that will pause your payment obligation, they are usually implemented when a student goes back to school. In other words, unless you decide to go to graduate school, you will always have to make payments on a traditional loan .
Some private student loan providers, such as Discover, also have a “forbearance” provision that allows you to pause payments in the case of financial hardship, but it can only be used for a maximum of 12 months.
In all income share agreements, the student’s payment obligation will adjust with their income level. In most, if not all, income share agreements payments can be deferred or forgiven if their income falls below a certain level ($50,000 at Lambda, or $20,000 at Purdue).
Income share agreements provide students with flexibility, financial stability, and information. They are more flexible than loans, because payments fluctuate with the student’s ability to pay. This enhances their long-term financial stability, especially when combined with a strong income floor. Because of this flexibility, investors have an incentive to accurately predict a student’s future income in order to determine the price of a new income share agreement. This price convey’s valuable information to the student about their earning potential, given their current choices, which may lead them to choose more prosperous careers.
Some people do not think so. They think that this price differentiation (or discrimination, depending on your perspective), leads students away from the true purpose of a university education. They also claim this could lead to discrimination that would run afoul of fair lending practices. For example, if white people make more money on average than black people, should that be factored into an ISA? I will address these concerns in a future post. ↩︎