Are ISAs fair? Can they increase labor market outcomes or access to education?

This is the first article I will write on ISAs and contains the most background information. To briefly introduce ISAs for those not familiar, they are a financial instrument that students can use to pay for their education without taking out debt. In an ISA, an institution says to a student “You can study here, and you don’t have to pay us right away, but you have to pay us a portion of your future salary”. The key components of ISAs are:

1. The term (the defined period of time after graduation during which a student must make payments to a university)
2. The cap (the total possible multiple of tuition a student might pay back, usually 1.5–2.5x tuition)
3. The floor (the minimum repayment amount required even if the student does not successfully gain employment)
4. The rate (the percentage of a student’s future salary to be paid back each month)

Who pays for ISAs?

When I say, “Who pays for ISAs?” I’m referring to the financiers that provide the money up front that actually covers the costs of tuition for the student. As of writing, ISAs are most frequently used for coding bootcamps. The ISA financier’s role is to provide the money that schools use to finance the operations of delivering education. In this regard, it’s incorrect to think of ISAs as “college is free now, student pays later”.

There are two models for ISA providers: B2B and B2C (I intentionally omit agencies that allow you to refinance loans with an ISA for simplicity) In the B2B model, an ISA provider works with a school to provide liquidity so that the school has the funding required to cover the cost of the student’s education. Schools will often participate by funding part of the ISA as well, because it signals to students that schools are willing to put their money where their mouth is, and because it signals confidence in successfully providing the student strong career outcomes. In the B2B model, students enter into an agreement with schools, and the schools then enter into an agreement with the ISA financier. In the B2C model, however, students go to ISA financier directly to secure financing for their education without the education institution as an intermediary. In either case, the ISA financier only recoups their investment once students are out in the labor market and earning money; the primary difference is the role of the school as an intermediary.

How do you keep ISAs fair?

ISAs are challenging to sell to students because they aren’t as intuitive as student loans. Student loans are the same as any loan, but for school: I give you $10,000 to pay for school, and you have to pay it back plus 10% interest (or however much principal and interest). But ISAs are weird. An underappreciated aspect of ISAs are that they’re effectively a hedge against the possibility that you don’t have future earnings. If you’re going to get a CS degree with the idea that a quantitative hedge fund will pay you $300k/year upon graduation, then you probably want a loan, because you’ll only have to pay back principal (tuition) plus interest (~4.5%). Whereas with an ISA, you might have a cap of 2.5x, and instead of paying back principal plus interest, you’re paying back 2.5x tuition price. In this situation the ISA is a clearly inferior choice.

But students may not fully grasp the tradeoff. The point I’m trying to make is that for someone in the business of ISAs (either a offering ISAs or an ISA financier), it’s crucial that students fully understand the terms of the agreement. If students don’t fully understand the deal, there will be more and more issues where students cry foul about the deal they’ve been given (when in all likelihood they just didn’t read or understand the fine print). As a school or ISA vendor, you could (and should) provide students with a graph that shows at which total annual compensation level after graduation the costs of an ISA and loan would be equal to each other (the “indifference point”). At the indifference point, an ISA and loan are equally good choices. Above that point, the loan is cheaper, but below that point, the ISA is cheaper. Although a student won’t know exactly how much they will earn after school, most have a rough idea or can be educated about the possible ranges to expect across career choices, and going through this exercise will help elucidate the tradeoffs of cost and risk.

The indifference point outlined above is just one example of ISA transparency. In reality, you want ISA recipients to understand all of the different levers you can pull to change up the ISA structure. While it may seem Sisyphean to spend time educating an 18 year old college hopeful on the implications of each permutation of term, cap, rate, and floor, it’s absolutely crucial, especially with a nascent asset class. And that is the beauty of ISAs, after all — they are extremely customizable. If you are able to build out the capacity to make these instruments suit the recipient, you can come up with contracts that make everyone happy more frequently than loans do.

Could growing ISAs as an asset class increase access to education?

Yes — growing ISAs as an asset class might both grow the pie of students attending higher education but also increase the share of students using ISAs as opposed to loans. Growing the pie is great; if we can deploy as many ISAs as possible in a responsible way for loan-averse students with a different risk profile that would otherwise not attend higher education, then we are already better off than before. These potential students are those at the margin who would not enroll in higher education if it meant taking out a student loan but would enroll in higher education with an ISA. ISAs could also increase the share of students using ISAs as opposed to loans. These potential students are those that would enroll in higher education and use student loans to finance their education, but would be better off had they instead financed their education with ISAs.)

This share shift would be powerful because it could help fix the incentive alignment problem that occurs with student loans. Currently, students borrow (potentially) over six figures of debt to finance their education. Because schools are paid upfront, schools have no accountability to ensure that students successfully find employment. And even more shockingly, if students are unable to repay loans, their social security can be garnished to pay down their debt! In this debt model, schools have no real accountability to their loan-based revenue (similar to lenders in the subprime MBS crisis). It is no wonder then that the student loan and student loan service industries have a hefty lobbying machine to preserve such a lucrative system for which there is limited inherent downside risk. This industry structure is one of the supports pillars that allows the predatory segment of the for-profit education system to flourish; the returns are higher for these institutions if they spend more on marketing to new students (who will take out and pay for school with loans) than if they invest in developing a stronger career pathway.

If you were to restructure the incentive system so that schools only get fully paid once students see labor market outcomes, then schools would be forced to make sure students have good labor market outcomes. Other intermediary steps would help as well, such as timing tuition payments from ISA financiers to schools (e.g., milestone payments: schools receive some money now, some when students graduate) to help ensure accountability over time. This shift to ISAs would be a free market correction to an incentive alignment problem that has left more people worse off than necessary.

If done responsibly, an incentive realignment would increase the number and share of positive outcomes! I bet, for example, that if some of the previously mentioned predatory institutions accepted ISAs, they’d be much more concerned with making sure those students got high-paying jobs after graduating. Because if the student leaves the school with a high-paying job, that means more money for the school! And the student! And the ISA financier! Everyone is happy. If you predicate this incentive alignment on the assumption that schools and ISA financiers will deploy ISAs in a fully transparent way and with student-friendly terms (covered more here), then you have the potential to make students better off both at the individual level and at the educational system level. The bottom line, which also happens to be the catch, is that for the unit economics of ISAs to work in the long run, student payment success must occur in aggregate, which requires proper incentive alignment along the way. There’s a lot of promise here but since the total value of ISAs originated today is currently so small, industry practitioners have to be extremely delicate with their actions.