Study: Simulating Investor Return on Traditional vs Alternative Student Loans

The one thing all Americans have in common is their debt anxiety. Even if we ignore the 28 trillion in federal debt, 77% of American households still have some kind of personal debt. With this staggering figure and a generation of borrowers who watched the 2008 market crash now plummet their families into financial stress, it's no wonder 56% of Americans say debt anxiety affects their daily lives. 

This study uses data from a variety of student loan debt assets to find the best loan investment for high returns. Here's what we found:

• Income Share Agreements (ISAs) are a potentially lucrative investment with a shorter time horizon than traditional student loans.
• ISAs benefit borrowers with greater flexibility, and investor profits correlate positively with borrower income. 
• ISA loans are paid off in half the time it takes to pay off traditional loans. 

What the fuck is up with student debt?

Since the Reagan administration in the 1980s, college tuition has steadily increased, and student debt has risen right along with it. Occupy Wall Street threw the $1 trillion student debt crisis into the social and political limelight in 2011, and the cost of higher education continues to be central to public discourse.

Total student debt currently sits at $1.7 trillion, and the need for loans shows no signs of stopping. $131 billion of this debt is from private providers, and 10-year loans are now taking more than 20 years to pay off.

Someone who takes out a loan at a rate of 3.75% and begins paying it off immediately after graduation still pays an additional 15.79% on top of the principal, and just one more year of deferred payment increases the return to the debt provider by 4.42%.

Not to mention, since debt is paid off over a considerable time horizon, loan providers can collateralize it and make additional profit on the money they have lent out.

Since profits from education financing are so high, it makes sense that many investors are interested in it, and there are a few choices for adding this asset to your portfolio. 

SLABS

The traditional choice for investors is to purchase SLABS, aka Student Loan Asset-Backed Securities. They're a kind of collateralized debt obligation (CDO). The structure of a SLAB is similar to bonds in the sense that there is a coupon rate, par value, and an assumed maturity.

SLABs can be purchased through brokers or in mutual funds but are not exchange traded.

Peer-to-peer Lending

Your next option is through Peer-to-Peer (P2P) lending. This relatively new way to finance loans primarily functions for businesses and personal loans. Most platforms aren’t actively advertising p2p loans for education, but they're out there, and the market for lending like this has grown a lot in recent years.  

ISAs

Then, of course, we have the Income Share Agreements (ISAs), which are student loans with shorter pay-back periods. The returns investors can earn correlates positively with the borrower's income.

An ISA is an agreement to share a percentage of your income after graduation in exchange for a student loan. This fixed rate is paid to the lender during a set number of periods and has a cap on the amount that can potentially be paid.

Payment ends when the student hits that payment cap or when a set number of periods has passed. This means that they could potentially pay less than they received or end up paying double what they borrowed.

Additionally, the percentage of income shared and the duration of payments is highly dependant on what degree you get and where you go to school (among other things). Extensive research has shown that Ivy leagues and STEM majors have much higher post-college salaries.

*Study did not include P2P lending in the analysis due to a lack of data and student loan-focused platforms.

From a risk perspective

First off, ISAs are riskier investments. The primary risks for an ISA can be referred to as 'underpayment' and default risk.

Underpayment is the biggest source of risk because an ISA can be fully paid off and still not total the amount lent out.

For example, A student who gets a $55k loan at a rate of 15%, a payment period of 48 months, and who gets a job that pays $105k a year (25th percentile entry-level data scientist salary) will pay only $54k by the end of the loan term. In this situation, the provider has a return of 22.73%. However, if the rate is just 3% lower at 12%, then in the same scenario, the provider loses $1k.

Default is the risk of a borrower simply never paying the money back.

While SLABs have default risk, they don’t have 'underpayment' risk but, in exchange, have to deal with prepayment and rate risks.

A student in a SLAB may have a super high salary and pay off their debt way sooner than expected—meaning that the predicted interest payment profit disappears for the lender. This is the prepayment risk.

Also, since SLABs are structured as bonds, they have rate risk. Their price will drop if rates increase due to the inverse relationship between them.

So, while SLABs do still have some risk, their nature as a bond and lack of 'underpayment' risk makes them safer than an ISA.

From a time horizon perspective

The next thing to note is that an ISAs return is less depending on the investment time horizon than a SLABs return.

As was already mentioned, SLABs suffer from interest rate risk, and therefore the return is highly dependent on federal interest rates, which have increased recently. A bond eventually is worth the same amount as its par, but the price you can sell it for depends on when you sell it and its maturity.

It can sell for a premium or at a discount, depending on the current rate and the rate you bought it at.

For example, a bond bought two years ago when interest rates were super low will sell at a discount because raising rates will decrease prices. Since a bond closer to its maturity has less time to recover from increased rates, the price you can sell it for will automatically be lower.

On the other hand, ISAs will return consistently year over year. Yes, the longer you hold, the more you will make, but no matter what happens with federal rates, your investment will continue to yield the same amount.

The return potential is also quicker and higher for ISAs. Using a similar example, a student who gets a $55k loan at a rate of 16%, a payment period of 48 months, and who gets a job that pays $105k a year with no pay raises over the payment period will pay $67k by the end of the loan term.

In comparison, a student who gets a traditional loan and begins making $300 payments immediately after graduation will only pay around $63k. As you can see, the ISA makes $4k more, and returns are realized significantly faster (4 years versus almost 30).

However, a student with an almost identical ISA to the one above, except their income share rate is 12%, will only pay $50k by then end of the term. That is $5k less than the loan was for so the ISA provider operates at a loss.

Jdickler. (2022, May 6). This is how student loan debt became a $1.7 trillion crisis. CNBC. Retrieved September 15, 2022, from https://www.cnbc.com/2022/05/06/this-is-how-student-loan-debt-became-a-1point7-trillion-crisis.html

Ramsey Solutions. (2022, July 14). Average American Debt. Ramsey. Retrieved September 15, 2022, from https://www.ramseysolutions.com/debt/average-american-debt