Every year, over 2 million students graduate from university in the UK, and the majority start their working life with a student loan debt. A student that did a three-year course could have a student debt of around £50,000, so at what point would it make sense to repay the student loan early?
How do student loans work?
There are different types of student loans depending on when you started university and where you are from; we will mainly be discussing Plan 2 loans for graduates from England or Wales, who started their undergraduate course in 2012 or later.
There are two bits to the student loan; a tuition fee loan which is around £9,250 a year and a maintenance loan to help cover living costs of between £3,597 and £12,667 per year. Plus, the loan starts to accrue interest even while studying - you can see how the numbers start to add up.
You start repaying in April after you have left your course, and from then on, pay 9% of earnings above a threshold which is currently £27,295. If you never earn over that £27,295 threshold, then you will never repay a penny of your debt.
All student loans are repaid through payroll just like income tax, which means that once you are working, your employer will deduct the repayments from your salary before you get it. So the amount you receive in your bank account each month already has it removed. The final key detail about the student loan is that it gets wiped after 30 years or if you die (i.e. it is not passed on to dependents).
Student loan or graduate tax?
To repeat…the student loan repayment is based on income. This is why many people prefer to call the student loan a graduate tax. The money you have to repay each month is relative to the amount you earn above £27,295, not the size of the debt; that’s very different from, say, a mortgage where your monthly repayments depend on the size of the loan and the interest rate.
If your salary is under £27,295 per year, you pay back nothing.
If you have a salary of £28,295 a year, £1,000 above the level of the threshold, a 9% slice of that would be £90 a year, or £7.50 a month.
Someone on a salary of £60,295 has nearly £32,000 of income above the level of that threshold, a 9% slice of that would be £2,880 a year, or £240 a month.
While your repayments are fixed to income, the interest on your loan will build over time. The interest rate you are charged depends on your income, but it’s currently capped at 6.3%. This is an important point - if you are never going to be a high income earner, then the interest rate really doesn’t matter. You could have 100% interest and you will still pay the same amount over the 30 year time period.
Should high earners try to beat the added interest and pay off the loans early?
It is calculated that if you are earning over £50,000 by age 30, then there is roughly a 50-50 chance you will pay back the entire loan. Above that level of income, it could mean it is mathematically advantageous to repay early, depending on personal circumstances.
There is no guarantee that your salary level is going to continue to be high for 30 years. There may be a change of career, an illness or accident, or caring responsibilities - all kinds of personal reasons why salary might change.
IFS research has found that because women are much more likely to take time away from the labour market and because they are likely to not have the same sort of career trajectory as men in their thirties, women are less likely to pay off their loans and so it makes less sense to make overpayments.
Suppose you pay a large sum when you don’t think you need the money, and then the day comes when you do need the money, maybe because you are out of work or you want to start a business, or for a down payment on a house, then you cannot take it back.
If you do decide to pay back your student loan early, you can never get that money back if your circumstances change.
There is also the political uncertainty of assuming the system stays in place for the next 30 years; what we have actually seen over the last 10 years is constant change. The parameters of the system are fundamentally reformed every two or three years - you could find a situation where overpayments are made towards student debt and then the government decides to increase interest rates or even cancel all student debt!
What about middle earners?
The student loan could end up costing middle earners more in the long run than higher earners.
If you’re earning £40,000 a year, you might finish off repaying more than if you were earning £100,000 a year, because if you earn more, you will be making bigger repayments each month and therefore pay off the loan faster, so there is less time for the interest charges to build up.
However, if you are on £40,000 a year, you may be making repayments for the full 30 years and as the interest builds up, the total amount you pay off over the years could be higher.
Paying off a student loan early or investing?
There is a double meaning to the word investing. The traditional view is investing in assets like the stock market to grow money for future use. Then there is investing in life in the present time to make the most of your youth; having life experiences and building memories is certainly money well spent – spending on products or belongings is more questionable.
Don’t focus on the student loan, it’s a contingent tax that you will pay if you earn and you won’t pay if you don’t.
Create your financial plan deciding where you want your money to go beyond just living costs and then stick to the plan - hopefully saving money as you earn.
Pay off any ‘bad’ debt, set up an emergency fund, and have some money set to one side in savings to pay for near-term spending like a holiday, laptop, or Xmas presents!
Then with your allotted savings/investment money, decide whether you should be investing or saving within a Pension, LISA, or ISA, depending on the time period and objectives.
Finally, AUTOMATE – set up your monthly affordable direct debit into your saving/investment plans, then switch off your computer and go enjoy life.
As a passive global low cost index investor, our belief or strategy is to ‘Buy and Hold’ and the great companies of the world over time with reinvested interest and dividends and Compound Interest will make us wealthy.
If you are fearful and couldn’t stomach a 30% fall in your Equity portfolio, then spread the risk, or volatility, using multi asset funds. A sound asset allocation strategy ensures your investment portfolio is one you can hold without fear for the long term throughout market downturns.
Will student loan affect my mortgage offer?
Student loans do not go on your credit report, so have no impact on your credit score when getting a mortgage. However, they do impact your ability to repay because you have a lower take-home income. This comes into play in your affordability score, rather than your credit score, and can reduce the amount you borrow, but the effect of this is minimal. Other bad debt, for example, would have more effect.
A more crucial factor in getting the best mortgage deal is the deposit - the bigger the deposit, the cheap the mortgage. For every extra 5% of the property value you manage to save up to 40%, rates tend to get cheaper. So, foregoing a bigger deposit to get rid of student loan would likely cost you, especially as saving in a LISA or Help to Buy ISA means the state will boost your deposit by 25%.
Looking ahead, there are changes on the horizon for people starting university next September. Here are three you need to know about:
1. The repayment threshold will be lower. It will start at £25,000 and then it will also be frozen for even longer than for the previous cohorts.
2. The repayment period will be extended from 30 years to 40 years.
3. The interest rate will be cut substantially. Everyone will be paying interest at the rate of RPI inflation, which is much lower than the current rates.
The question is who wins and who loses from these changes?
Some of the high earners who will be paying off their loans really benefit from the interest rate cut, whereas for low and middling earners, the lower repayment threshold and the longer repayment periods actually means they might be repaying more.
Should I pay off my student loan early?
I will leave the final word to Martin Lewis of Moneysavingexpert.com:
Student loan statements can lie, as, unlike other debt, the interest added ISN'T the interest paid. That depends on future earnings. Some won't repay any interest and most won't earn enough to repay close to all of it.
The Institute For Fiscal Studies estimates 83% with English student loans won't clear the debt (including interest) within the 30 years.
If you're 100% certain you'll be a big earner for the next 30 years, then at current rates you would be better off paying off this loan.
For everyone else, I'm tempted to say 'rip up your student loan statement' – it's just frightening and irrelevant. Just accept you'll pay a 9% increased tax-like burden.