Student Loans (Post-2012 System)
Background and Current Position
Students can usually apply for a student loan to cover university tuition fees and to contribute towards maintenance costs while studying. The maximum borrowing in relation to the maintenance loan depends on where students live while studying and on their parents’ income.
The interest added to the student loan depends on the student’s income, as follows:
Interest rates are updated with effect from 1 September each year, and are based on the change in the inflation figure (as measured by RPI) for the year to the preceding March.
Individuals are required to begin making student loan repayments from the April after they leave their course.
Repayments are calculated as 9% of the individual’s income in excess of a threshold (£25,000 gross per annum from 6 April 2018). Those whose income is below the threshold (for whatever reason, including career breaks to look after children and periods of ill health or unemployment) do not have to make any repayments at all.
Unearned taxable income (such as interest, dividends and chargeable gains) of up to £2,000 is disregarded, though if unearned taxable income exceeds this figure, the full amount (not just the excess) is included in the calculations alongside earnings.
If individuals move overseas, they must still make repayments, calculated as 9% of the their income in excess of the relevant threshold for the country in which they work.
Importantly, there is no direct relationship between the balance of the loan outstanding, the interest rate, and the repayments required. There is only an indirect relationship, in that the larger the balance and the higher the interest rate, the longer it will take to repay the loan.
Crucially, however, if there is still a balance outstanding at the time, the rest of the student loan is fully written off 30 years after the student is required to begin making repayments (or earlier in the event of death or being permanently unable to work due to disability).
Effective Interest Rate
Given the large amounts that students often now borrow, the relatively high rates of interest, the relatively high repayment threshold and, above all, that the student loan is written off after 30 years, the majority of today’s students are not expected to fully repay their student loans.
“83% of graduates will not have fully repaid their loans by the time they are written off 30 years after graduation” (Source: Institute for Fiscal Studies, 3 October 2017)
Because of this, the interest rates detailed above are often irrelevant. For those who do not fully repay the amount borrowed (over the 30 year period), the “effective interest rate” on their student loan is negative.
For those who fully repay (over the 30 year period) the amount borrowed but not all of the interest, then the “effective interest rate” on their student loan will be greater than 0%, but lower than the interest rates detailed above.
Generally speaking, for individuals with a fairly typical £50,000 student loan balance upon graduating, they will need to be higher rate taxpayers for a prolonged period to fully repay the amount borrowed and all of the interest.
The terms attached to student loans are very different to commercial loans, so while many parents may want to provide their children with a debt-free start to their adult lives, there are strong financial arguments for viewing student loans as an odd kind of graduate tax, rather than a debt.
In almost all cases, there is financial value in today’s students taking out a student loan, even where it is not required. This is on the basis that we expect it to be very rare that an individual will have sufficient certainty that they will repay their student loan before even starting their course.
If student loans are taken, they should generally not be repaid any sooner than necessary until there is sufficient certainty that the individual will fully repay (from their income) both the amount borrowed and the interest within the 30 year period.
This will often mean waiting until individuals are higher rate taxpayers, with a high level of job security and a healthy career trajectory ahead of them, and with a student loan balance that has been significantly reduced relative to its initial level through repayments from income.
Even if the student loan would be fully repaid within the 30 year period, individuals with sufficient liquidity to repay the loan sooner than necessary should still carefully consider other options, such as tax-efficient long-term investments that provide greater liquidity and therefore flexibility. For example, surplus income or capital may be better directed to contributions to pensions, ISAs or Lifetime ISAs, or directly towards a first property purchase.
It is quite possible that individuals may achieve long-term investment returns similar to (or better than) RPI + up to 3% per annum, particularly if taking advantage of appropriate tax reliefs. But, even if they do not, because the interest applicable to a student loan applies to a reducing balance, while investment returns apply to a compounding balance, it may not even be necessary to beat the student loan interest rate to come out ahead financially (even RPI + 1% may be enough).
One final point to consider is that governments may change the student loan system in the future. We consider that political changes, if any, are more likely than not to be favourable, given the significant media attention garnered by record student loan balances and relatively high headline rates of interest, even though these are irrelevant to most students.