What are the pros and cons of income share agreements for partially funding higher education. Are investing in ISA’s a viable opportunity?
Topics covered include
- How do income share agreements (ISAs) differ from student loans for funding higher education costs.
- Are ISA’s really a partial form of slavery or indentured servitude
- What are the components of an ISA contract.
- How adverse selection, differential pricing, moral hazard, and a lack of regulation pose challenges to income share agreements.
- What is an internal rate of return and why is it the best metric for estimating the return of investing in ISAs.
- How students should evaluate ISA’s relative to loans.
- What are some examples including prices for specific ISAs
- What options exist for investing in ISAs.
Update: The management fee schedule for Edly was explained incorrectly in the initial episode audio. The fees are applied to cash flows received rather than the account balance. This results in a lower overall fee. The podcast audio and transcript have been updated to reflect this change.
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 307. It’s titled, “Income Share Agreements: Good for Students or Investors?”
Income Share Agreements Defined
Over 5 years ago in episode 45 of Money for the Rest of Us, I introduced income share agreements as a way to partially fund college. An income share agreement is a contract where individuals agree to pay a certain percentage of their income for a set period of time in exchange for an upfront payment that is usually used to pay for education costs. But can be used for other things.
For example, Align Income Share Funding says that you can get an ISA for home repairs, debt consolidation, paying a medical bill, or even planning your wedding. Not sure I would do an income share agreement for most of those things. They are traditionally used to invest in what is known as human capital, our ability to earn money by getting more education. Another name for income share agreements is human capital contracts.
Income share agreements were first proposed by the economist Milton Friedman in a 1955 essay titled “The Role of Government in Education.” He wrote, “vocational or professional education is a form of investment in human capital, precisely analogous to investment in machinery, buildings, or other forms of non-human capital. Its function is to raise the economic productivity of the human being. If it does so, the individual is rewarded in a free enterprise society by receiving a higher return for his services than he would otherwise be able to command.”
Investing in Human Capital
We discussed this concept a little in episode 245, “Is College Worth It?” and determined there is a positive financial return in investing in human capital by attending college. You can earn more. You build your social capital, your network. You gain knowledge. Having a college degree allows you to pass filters that many companies put in place with their hiring practice in that they only hire individuals with college degrees.
Friedman continues, “If a fixed money loan is made to finance investment in physical capital, the lender can get some security for his loan in the form of a mortgage or a residual claim to the physical asset itself. And he can count on realizing at least part of his investment in case of necessity by selling the physical asset.” In other words, the lender has some collateral that could be sold in the case of default.
But Friedman points out a problem. If the loan is made to invest in human capital. He writes, “The lender clearly cannot get any comparable security in a non-slave state, the individual embodying the investment cannot be bought and sold.” Friedman then pointed out that because there isn’t collateral, that the interest rate charged on student loans would have to be sufficiently high to compensate for the capital loss because there wouldn’t be collateral. And that the interest rates would have to be so high, making the loans unattractive to borrowers.
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