Income sharing agreements - The low risk option for students (and investors)
Brighter Investment’s mission is to ensure that every talented student worldwide can afford quality education. In this mission, quality is not limited to good teachers and effective state of the art education, but includes long term value creation for the student. Unfortunately it is a well known problem that many students in North America, uninformed about the true career prospects that come with their degree, take on student debt that can hardly be repaid. These students often end up with a very low or even negative return on their higher education investment. This blog post describes the three reasons why that problem does not apply to Brighter students:
Reason 1 - The higher education ROI is very large in developing countries.
Reason 2 - Our model is intrinsically focussed on value creation.
Reason 3 - Our student financing terms are fair under all scenarios.
Because this post addresses a subject that's important to us, it is a detailed and thorough post. If you are a student and have questions about this subject don't hesitate to contact Richard at r.adarkwah@brighterinvestment.com. Tyson can help if your question is related to investing, reach him at t.titensor@brighterinvestment.com.
Reason 1 - The higher education ROI is very large in developing countries:
In developing countries, a negative return from pursuing higher education is very unlikely. The factor that has the largest influence on the ROI from investing in a degree, is the increase in income the degree realizes for the student. I.e. how much more does a graduate earn with their degree than they would have earned if he/she would have worked without the degree? In the developed world this income increase falls in a range from 1X (no increase at all) to 2X (for the best degrees); in developing countries, this income increase is typically in the 3-5X range. The much higher return results in a much higher margin for repaying the investment without getting into negative ROI territory.
If you are one of the students fortunate enough to earn a chemistry degree in Ghana, your income increases 5X with your degree.
Reason 2 - Our model is intrinsically focussed on value creation:
At Brighter Investment, students repay a percentage of their income for a set number of months, rather than a principle and a fixed interest rate. This means that the uncertainty around the recoupability of the degree investment shifts from the student to us, the financier. Under our model, a student can never end up with a loan they can’t repay. Between the student, the education provider and the financier, we are the party that is in the best position to independently assess the career prospects and ROI for a specific degree program. It is in our own interest to not push as many loans as possible, but finance students that we expect to create value, value for our investors and value for the student themselves.
As an independent third party providing students with direct feedback about how their degree choices affect future career prospects, we stimulate higher education providers to further improve the value they create for their students. We have already had a professor at one of our partner universities asking why his students got less favorable repayment terms than students of the same degree at a different partner university. We could show him that his graduates earn less than the graduates from the other university, and that it was not necessarily a university wide reputation issue. This prompted the professor to say he’d look into why and solve it. If he is successful, this will show up in our data and cause us to improve repayment rates for his future students.
The pursuit of value creation that is an intrinsic part of our model further reduces the number of students that don’t realize a positive financial result from their degree. The income sharing agreement ensures that even the small percentage of students that don’t realize the expected income increase won’t end up with insurmountable debt.
Reason 3 - Our student financing terms are fair under all scenarios:
Brighter Investment doesn’t face any real competition in the multi year student loan markets we serve and we are in a position where we can, within reason, dictate repayment terms to students. The 3-5X increase in income, and focus on students that will get the most value out of their degree, means that even when charged high repayment percentages, the student would still be better off with his financing than without. Especially since on an individual level, unlike for a traditional student loan, our income sharing model means that also less successful students only end up having to repay what they can afford.
In the longer term, competition in this market should set a repayment limit that balances the need for investor returns with student interests. A competitor promising too high a return will see students going to the competition, too low a return will mean not enough capital to support new students. That said, at Brighter Investment we believe that both from an ethical as well as a long term business perspective, we shouldn’t take advantage of our current position of first-mover power in an uncrowded market. BI already offers fair repayment terms to our students. The next three examples show how under different scenarios the repayment terms remain fair, and how the repayment terms fit in the local context.
Scenario 1 - Low inflation and matching wage level growth
Our students repay 25% of their pretax income to Brighter Investment. The exact repayment duration varies from degree to degree, a civil engineering student for example that receives support for 4 years, makes repayments for 6 years. In general, repayment term duration varies between 5 and 7.5 years for the degrees we support. Repayment durations are proportionally shorter for students that only receive support for 3, 2 or 1 year.
On average, over the last 35 years, developing countries have had an inflation of 4% or lower in approximately 1 out of 3 years[1]. If wages increase by the same amount per year over the duration of a student’s education and repayment, the expected effective interest rate an average student repays under this scenario is 12%[2]. The average student will repay the invested principal plus this 12% ROI. In comparison, we note that average OSAP (Ontario Student Assistance Program) debt for a 4-year university degree student is $22,207[3] and takes 9.5 years to repay[4]. OSAP debt repayment is capped at 20% of family income[5].
Students performing better than average (based on our selection algorithm, we expect many students to perform above average) will consequently earn more than average and will repay more than this principal plus effective interest rate of 12%. Once a student’s repayments hit the threshold of repayment of the principal plus an effective interest rate of 21% + official inflation index, this student is done repaying, irrespective of the remaining length of the repayment period. This means that under the current scenario, the maximum effective interest rate paid by the most successful students is 25% (21% + 4%). To reach this threshold before the end of their repayment period, students need to earn twice the average income of their peers with the same degree. Our first repaying students are performing significantly better than the average graduate and we expect a small percentage of graduates to reach this threshold before the end of their repayment period, but it is too early to tell what percentage.
To put these interest rates in perspective, we look at loans provided to students by Kiva through a local micro credit partner. Characteristics:
Typically small and only available for a short term.
Usually used to buy a laptop or pay tuition
Borrowers typically repay the loan over the course of a year.
Help families that can afford the cost of higher education, but can’t afford the one-off large payments.
The typical cost to borrower, where Kiva puts pressure on their partners to keep costs reasonable, is 30-50% per year[6].
Of course, overhead is much larger for these lenders as loan amounts are much smaller. But at the same time, cost of capital from Kiva donors is 0%. A major difference between these micro credit loans and our model is though, that these interest rates apply to ALL borrowers, also the ones that don’t successfully use their loan to generate additional income. Under our model the top rate only applies to the successful students that can afford to repay these amounts.
There are two types of uncertainty that hold the potential to leave borrowers of traditional loans with insurmountable debt: 1) macroeconomic fluctuations in inflation and wage levels (which will be addressed in the next section) and 2) individual changes in fortune and income. Our income dependent repayment has the advantage for the student that it takes the uncertainty of his or her performance out of the equation. To an investor invested in a large diversified cohort it doesn't matter that one student pays more and another one less, well known average rates determine the ROI. To a student that isn’t successful in his/her career, it makes a huge difference to not be left with an unrepayable loan that can easily be 5 times the family's annual income.
Scenario 2 - High inflation and local currency losing value against USD/CAD
There is a correlation between inflation, wage levels and exchange rates. Inflation usually goes hand in hand with rising wages and a decreasing value of the local currency. Especially over longer periods, like our 12 year investment period, this correlation is strong. In developing countries, traditional loans lost an avg. of 8% of their value in USD per year over the last 20 years due to exchange rate changes. Wages converted to USD were less affected and gained 5% per year on average. Volatility of these wages was 5.4% in the last 20 years[1]. For S&P500 returns volatility was 18%. Because investors are repaid based on a percentage of our graduates’ wages that mostly maintain their value in USD, this correlation provides a natural hedge against fx fluctuations. For more details about the effect of fx fluctuations on your investment see our financial projections.
Examples of correlation between inflation, exchange rates and wage levels in USD. Even if inflation is high and the local currency loses value against the USD, average wages when converted back to USD maintain their value over longer periods.
The reason cost to borrowers charged by the Kiva partners in Ghana is so high, is partially the high overhead for small loans, but for a large part it is also the result of uncertainty of inflation. Most lenders are financed in USD, but give out loans in local currency. To ensure that these lenders don’t become insolvent during periods of high inflation, they need to charge these high interest rates.
As mentioned in the previous section, the two types of uncertainty that hold the potential to leave borrowers with insurmountable debt: 1) individual changes in fortune and income as described in the previous section. And 2) macroeconomic fluctuations in inflation and wage levels. The effects of these uncertainties become more pronounced when interest rates are high. For a traditional interest bearing loan, interest rates are set for possible high inflation, but inflation may not happen or wages might not keep up with inflation. Under these circumstances of high interest rates and low inflation/wage growth, students end up with insurmountable debt. For our students monthly repayments are tied to income, not inflation or exchange rates, so students’ effective interest rate only goes up if wages go up and they can afford the higher effective interest rates.
There will be years where wage growth in local currency lags behind a decrease in the USD value of the local currency. Investors can take on these year to year fluctuations in roi. They can make up for a lesser year in other years as long as the risk is properly priced. Graduates repaying a traditional student loan on the other hand are usually less easily able to cough up higher interest rates during periods of low inflation, even though they may be compensated in other years with higher inflation. Under our model, macroeconomic uncertainty around inflation and wage levels have been eliminated for students as repayments are directly tied to their income level. At the same time, fx risks have also been reduced for the investor as local wage levels, that determine the ROI, are much more stable converted to USD than the value of a traditional loan denoted in the local currency.
Since we’ve started tracking wage levels in Ghana in 2014, annualized inflation has been 16% and wage growth for graduates 23%[7]. Because the Ghanaian Cedi has lost value against the USD, wages converted back to USD have only gained 2.5% annualized over the same period. If this level of inflation would continue for 11 years (average duration for students to graduate, complete an internship, find a job and complete the repayment period) and wages would continue to keep up over these 11 years, the average student would repay an effective interest rate of 29%, the maximum interest rate would be 37%. Effective interest rate would fall within the range of acceptable as set by Kiva for Ghana and within common bandwidths under current market circumstances in Ghana. If wages don’t keep up with inflation, average effective interest rates would be lower. With unchanged inflation the cap would remain the same, but less students would earn enough to reach this effective interest rate cap.
High growth in wage levels and inflation doesn’t make a difference in the capacity for the student to repay, nor the lifestyle he/she can afford with the remainder of the wages. The case we’re trying to make here, is that effective interest rate is just an economic number that will be determined by factors like inflation, exchange rates and average wage levels. These factors are outside of our, and especially outside of the student’s influence. Much more important to the student is that inherent value they repay is constant, remains payable for the student without problems, and remains fair to investors, whatever direction the uncontrollable tides of macroeconomics move.
Scenario 3 - Unemployment and Defaults
A student’s repayment period is set as a number of working months. Every month a student has work, whatever job it is, a month gets deducted from the repayment period. After a three month grace period at the start of the repayment, every month a student is unemployed before completing their total repayment period results in 0.25 months added to the repayment period. Under normal circumstances this 0.25 month corresponds with an effective interest rate of the average student. This means that a student that is unemployed, but otherwise earns the same as a peer that works every month, eventually pays approximately the same effective interest rate.
If a student has a low income, he/she pays a percentage of this lower income and the month will still count towards the repayment period. A minimum income level set at approximately 5x minimum wage, and higher than the income of an average employee with only a high school diploma, ensures that no student ends up with insufficient funds for a decent living standard. Our financial projections for investors are based on what the average graduate with a certain degree earns, including the less successful graduates. Our selection method is geared towards selecting students for our program that will perform above average.
The minimum income and unemployment clauses in our sponsorship contract mean that a student can’t default for a lack of income. The only reason they can default is if they consciously try to take advantage of our program. Our in house collection is geared towards talking to students that are behind on their payments and get them back to paying as soon as possible. This collection is relatively easy because we don’t have to deal with situations where the money simply isn’t there. It is only when a student refuses to cooperate that a secondary repayment schedule kicks in and we bring on an external collection company to collect on the debt.
Brighter students at the University of Mines and Technology. One of our partner universities that our research shows to offer good career prospects.
Conclusion
In developing countries, the ROI from getting a degree is very large and our business model is geared towards a shared value creation. These two aspects make it very unlikely that a student does not benefit from our financing.
Our income sharing model, where graduated students repay a fixed percentage of their income, takes away the uncertainty for a student around personal success and the repayability of a loan. If a student has a low income, the repayments they are required to make are low or even 0. Taking away the risk of insurmountable debt makes a big difference to a student. Especially in developing countries where the money required to get a degree often exceeds 5 times the family’s annual income. For an investor however, risk doesn’t significantly increase as he/she is invested in a large diversified cohort of students where returns are determined by the predictable performance of the average student.
Inflation and wage levels also influence the repayability of a traditional student loan. This macroeconomic uncertainty has also been eliminated for our students by tying repayments directly to their income level. This has, at the same time, reduced fx risks for the investor: Local wage levels converted to USD, that determine the ROI, are much more stable than the value of a traditional loan denoted in the local currency.
Our income dependent repayment means that effective interest rates can be high for successful students, especially if inflation and wage growth are high. But even under these circumstances effective interest rates stay within a reasonable bandwidth in the context of developing markets facing high inflation. Much more important to the student is that the inherent value they repay is constant, and remains easily payable under all circumstances.
Sources:
[1] Combination of data from: World Development Indicators - World Bank & The Occupational Wages around the World Database - World Development Report
[2] Effective interest rate target for average students as set based on our own data
[3] Average OSAP debt - Government of Ontario - visited March 2018
[4] OSAP debt calculator - OSAP - visited March 2018
[5] Pay Back OSAP - Government of Ontario - visited March 2018
[6] Kiva website - visited March 2018
[7] Annual wage research - Brighter Investment (only degrees of interest to us were included in the research)