Which is more like indentured servitude: Income share agreement or student loan?
We have heard the concern that income share agreements (ISAs) can be like indentured servitude. At face value, this seems plausible, given the notion of “income sharing” embedded in the name of this financing option. I would like to dispel this criticism of ISAs in this note, including the substantive nature of this argument and the aspects driving this perception.
In simple terms, an educational income share agreement is an obligation, but not a loan, where a student gets funded for education and pays back the obligation over a certain number of months, and the payment is calculated as a fraction of monthly income. Payments pause or are forgiven if income falls below a minimum threshold. If the payment term is completed (with or without payment) or if a maximum cap amount is paid, the obligation is over. Learn more about ISAs here.
Every good measurement needs a benchmark, and I will use loans as they provide the natural comparison group. Loans certainly have their place, and it is not my goal to criticize them. I am simply creating a description of how a well-accepted education financial contract (loan) as of this writing compares to an ISA in terms of the “indentured servitude” perception.
Thinking through the indentured servitude argument
The Merriam-Webster dictionary definition of indentured servitude is “a person who signs and is bound by indentures to work for another for a specified time especially in return for payment of travel expenses and maintenance “
This is a bit extreme when it comes to financial contracts, because ISA or loan providers or educational institutions do not ask people to work for them against a contract. With regards to ISAs, there is a sense of ‘wage capture’ primarily because payments are calculated as a percentage of income.
For our purposes, let’s start with the idea that any contract that obliges one to expend effort unwillingly to satisfy the terms of the contract is reflective of indentured servitude. Now, even this is likely extreme, as some people do not like their jobs, though they are free to leave them without paying something to their employer. That suggests that the following key components are necessary for something to approach the indentured servitude concept:
a. To work without wages,
b. Work to pay off the contract,
c. Inability to get out of a contract without payment,
d. Unwillingly expending effort to satisfy the contract.
Requirement (a) does not apply to either ISAs or loans, and disqualifies both from being classified as indentured servitude. Neither of these contracts force anyone to work without wages.
Requirements (b) and (c) are common for both ISAs and loans. Unless you are independently wealthy, you have to work to pay off both ISAs and loans. Also, you need to pay back some minimum amount to exit either of these contracts. I should mention that these are also characteristics of phone bills, utility bills, and credit card bills.
Requirement (d), it turns out, applies more to loans than to ISAs. If you do not want to work, you are free to do so, and make little or no payments on ISAs. Typically, ISAs have a minimum income threshold below which you do not have to pay anything. In a loan, on the other hand, interest adds to principal and may itself earn interest if you do not make your payments. Which means that, not only do you need to unwillingly expend effort to satisfy the contract, you pay more if you do not satisfy interest payments on time.
So, while neither ISAs nor loans fit the description of indentured servitude; as seen in a continuum of requirements, loans are arguably closer to an indentured servitude arrangement than ISAs.
The perception issue
While I would like to say “problem solved,” there remains a perception issue. The act of calculating someone’s payments as a fraction of their income makes ISAs seem like indentured servitude. It evokes images of “capturing” someone’s wages and feels like taking advantage of someone.
Again, I would like to make a few arguments to address this.
1. Many ISA contracts, and certainly ours, explicitly mention that we cannot garnish wages. The payments are made in much the same way loan payments, utility bills, and phone bills are.
2. Interest payments and ISA payments are both made from someone’s monthly income. The only difference is in the calculation of the payments. If ISA payments are “fixed” income share agreements, then loans are “variable” income share agreements (i.e., income share rate or monthly payment divided by income changes as income changes). So the only difference between the two is the way the payments are calculated. That hardly seems consistent with any sense of capture. So if loans are not ‘capturing income’ and are acceptable, then by that logic, so are ISAs.
3. Student loans in the US are effectively non-dischargeable (or very hard to discharge) through personal bankruptcy declaration. You have to pay back your loans, whether or not you can afford it, even if you are bankrupt. ISAs currently (as of 4/2019) do not suffer from this affliction. In addition, not being able to pay your loans leads to credit score downgrades, collections referrals, and potential lawsuits. In contrast, in an ISA, if you do not have sufficient income, you pay less or nothing.
In summary, I leave it up to the reader to decide for themselves whether ISAs are or are not indentured servitude. However, characterizing ISAs in that way would require the reader to make the same conclusion for student loans (which students are currently taking on in large numbers).
About the Author
Karthik is the CEO and Co-founder of MentorWorks Education Capital as well as a tenured Associate Professor of finance at Northeastern University and a former angel investor with Launchpad Venture Group. His teaching and research in the areas of entrepreneurship and education finance has made him a go-to-resource and thought leader on education financing having published various articles on the subject. He has mentored many students and assisted them in securing meaningful internships and jobs. Reach out to Karthik at email@example.com.