How to Evaluate Income-Share Agreements

Mark KantrowitzBy Mark KantrowitzBy Savingforcollege.com

Income-share agreements, or ISAs, are alternatives to student loans. But, unlike student loans, where you can compare interest rates and fees, how do you determine whether an ISA is expensive or not?

For example, an ISA where the borrower pays 10% of income for 10 years may sound cheap, but may ultimately cost you more than a traditional student loan.

What is an ISA?

Both ISAs and student loans are forms of education financing, where the borrower receives funding to pay for a college education.

The difference between an ISA and a student loan depends on how the monthly payment is calculated.

  • With a student loan, the borrower agrees to pay a fixed dollar amount per month for a specified period of time.
  • With an ISA, the borrower agrees to pay a fixed percentage of monthly income for a specified period of time.

In most cases, the total amount paid over the repayment term will exceed the amount borrowed, sometimes by several multiples.

With an ISA, the monthly payment may increase over time as the borrower’s income increases. With a student loan, the monthly payment will remain unchanged in a level amortization. However, there are alternative repayment plans, such as income-driven repayment, where the monthly payment may increase periodically.


How to Compare ISAs

The most important factors affecting the cost of an ISA are the percentage of income and the length of the repayment term.

To calculate the payment ratio of an ISA, multiply the length of the repayment term by the percentage of income per $1,000 in funding received.

For example, if the borrower agrees to pay 0.4% of income for 10 years for each $1,000 in funding, and receives $30,000 in funding, they will have agreed to pay 12% of income for 10 years, namely 0.4% x 30. The payment ratio is 4% per $1,000 in funding, or 12% x 10 / 30.

The payment ratio can be multiplied by the borrower’s annual income to calculate an estimate of the ratio of total payments to total funding.


Factoring in the Net Present Value

This isn’t a perfect metric, since it does not consider the time value of money (e.g., the net present value of the future stream of payments), nor the impact of annual cost-of-living adjustments.

For example, compare an ISA in which the borrower receives $30,000 and agrees to pay 20% of income for 10 years with an ISA in which the borrower agrees to pay 10% of income for 20 years. In both cases, the total payments are the same, assuming the income remains unchanged. But, with a discount rate of 2%, the net present value (NPV) of the 20-year ISA is about 9% less than the NPV of the 10-year ISA. Stretching out the same payments over a longer repayment term is worth less in today’s dollars.

Next, consider the same scenario, but with a 2% annual cost-of-living adjustments. The total payments on the 10-year ISA are 10% lower than on the 20-year ISA, but the net present value of those payments is about the same.

Nevertheless, the product of the repayment term and the percentage of income divided by the amount of funding provides a reasonable rule of thumb for comparing ISAs.


How to Compare ISAs with Student Loans

A similar approach works for comparing ISAs with student loans. One merely calculates the ratio of the total payments on the student loan to the total amount received.

Let’s compare an ISA with a student loan. In both cases, the borrower receives $30,000 net of any fees.

  • With the ISA, the borrower agrees to pay 20% of income for 10 years. The borrower’s annual income starts at $50,000 and increases by 2% annually.
  • The student loan has a 7% interest rate and 4% in fees, with level amortization over a 10-year repayment term. Assume that the average life of a loan dollar in an in-school or grace period is 32 months and that interest is capitalized once, when the loan enters repayment.

The payment ratio of the ISA is 6.7% per $1,000 of funding. Based on the borrower’s income and annual income increases, the total payments are $109,497. The ratio of total payments to total funding is 3.65, meaning that the borrower pays back more than three times the amount of funding received.

The total payments for the student loan, taking the loan fees and capitalized interest into consideration, is $51,668. The ratio of total payments to total funding for the student loan is 1.72, meaning that the borrower pays back about three quarters more than the amount of funding received.

Thus, the student loan is much less expensive than the ISA.

For the ISA to be in the same ballpark as the student loan, the payment ratio would have to be cut in half, such as by reducing the percentage of income from 20% to 10%.

Borrowers should be cautious when the payment ratio for an ISA is more than 3% per $1,000 of funding, if the borrower expects to earn a typical salary for college graduates. Traditional student loans are likely to be less expensive.


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