December 20, 2019
Education Loan, Income Share Agreement Loan, ISA Loan, Student Loan
As the US Presidential election draws near, the issue of student debt has once again come to the fore. According to some estimates, students who have taken loan to finance their higher education in the US owe lenders as much as $1.5 trillion. To put this figure in perspective, that amount is roughly equal to 50% of India’s Gross Domestic Product (GDP) and over five times the GDP of Pakistan.
The ever increasing cost of education coupled with falling income levels, job cuts and global economic uncertainty due to ongoing trade war between the US and China, have led many experts question the long term sustainability of the existing system.
As a result, certain financial and academic institutions are now beginning to experiment with loans linked to future earnings of students. These Income-Share-Agreement (ISA) linked loans or the ISA Loans allow students to repay the borrowed money without putting too much pressure on their monthly or yearly budget.
In this blog, Student Cover tries to explain what ISA loans are and how they work.
Originally proposed by Nobel Laureate Milton Friedman way back in 1955, the concept is akin to equity investment in a company where an investor invests capital to buy shares in the corporate entity and in return acquires right over a portion of company’s earning. ISA loans operate in the same manner with the only difference being that, instead of a company, lenders acquire right over future earnings of an individual for a particular time period.
In Income-Share-Agreement linked loan, a lender lends money to finance a student’s education. In return, the student is bound by agreement to share a part of his or her gross income with the lender over a certain period of time. The time depends on the amount of money borrowed and the interest that the lender expects to earn from the borrower.
John needs $50,000 to pay for his or her 2 year Masters Degree in Management. He expects to get a job with a salary of $120,000 per year after he completes his graduation. He promises the lender 10% of his/her monthly salary (i.e. 10% of monthly salary of $10,000 = $1,000). Therefore, it will take 50 months or 4 years and 2 months to repay the principal. If lender seeks interest of say $10,000 on $50,000 lent (making the total returnable amount of $ 60,000), he will have 60 months (5 years at $1,000/month) to repay the entire amount with interest.
However, if John fails to get a job with $10,000 per month salary and instead gets a salary of just $6,000 per month, he will not have to shell out $1,000 per month. Instead he will have to pay the lender 10% of $6,000 i.e. $ 600. This way, instead of 60 months, he will not have to repay it for a longer period of time which is 100 months ($600 x 100 = $ 60,000). That is equal to 8 years and 4 months instead of 5 year repayment period as agreed earlier.
In case he fails to acquire a job or gets a job with salary less than $5,000 per month, the agreement might also have a provision of deferring payment till his salary goes above a certain limit. Similarly, if he gets a salary higher than $10,000 per month, he will be able to repay it earlier.
What differentiates ISA loan from conventional education loans is that unlike the conventional loan products, the ISA is not determined by a fixed rate at which the borrowed money is to be repaid in the form of Equated Monthly Installments (EMIs) over a given period of time. Instead, the monthly installments depend on the income of the individual. This is not so in case of interest rate linked EMIs.
It is too early to reach a conclusion over whether ISA linked student loans are good or bad as it has both merits and demerits. On the plus side, it gives students an opportunity to repay the loans while not being under too much under pressure, while on the other side, it is a very complicated system to administer especially when students do not earn or earn very little for longer periods of time. This is because while lenders adjust interest rate on conventional rate depending on the lending rate of central banks, it is not so easy in case of ISA linked loan.
The other argument against it is probably with regard to the share percentage. Conventional loans have same rate of interest irrespective of the course or program that a student has enrolled himself or herself in. In case of ISA loans however, students might have to share more or less percentage of their income depending on the program. For example, a student pursuing master’s degree course in management in a top university is likely to earn more as compared to a student pursuing history in an average rated university. If the share percentage is more, then the management student would end up paying more for the loan as compared to the student of history.
The concept of ISA linked loan has been there for a long period of time. In ISA linked loan, students promise to part with certain percentage of their gross income to repay the loan that they have received. The rate of repayment thus depends on the individual’s income rather than the interest rate. This form of lending is being explored and employed by increasing number of financial and academic institutions. However there are still certain question marks over their long term sustainability, especially in the absence of clearly defined regulatory guidelines.
Disclaimer: This blog was written based on the personal research of the writer. Readers’ discretion is advised. Neither Student Cover nor the writer will be held liable for any wrongful interpretation of the content of this blog.
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