When graduates move along the road into employment, they will often find themselves with enough income where paying back student loans early becomes a real option. However, if I’m earning enough, should I be paying back student loans early, or is there other things I should be doing with my money?
First of all, if you are asking yourself questions about student loan repayment and whether you should be paying back student loans early or saving/investing the rest, you are ahead of a lot of people for two reasons:
- You haven’t already spent that additional income on fancy new toys – i.e. things that you want rather than things that you need.
- You are thinking wisely about your money and the best use for it in the future.
So, let’s look at your student loan repayment, and many possible alternatives to work out if you should be paying down student loans early or not.
What Is A Student Loan?
Easy question, right? Well, not entirely. Obviously, it’s a loan (money that you owe to someone else) which was taken out as a result of higher education, usually university education.
However, depending on when you took out your loan, the student loan itself and its varying conditions and rates can alter. Generally, student loans can be split into three types:
- Pre 1998 loans: The interest rate is based on the prior year’s RPI inflation rate. For instance, in September 2015 (and for the following year) the rate will change to match the 0.9% inflation rate recorded for the year to March 2015.
- 1998 – 2011 loans: The interest rate is based at the lower of the rate noted above for pre 1998 loans (RPI) or 1% above the Bank of England base rate. The base rate is currently 0.5% and so these loans currently incur interest at 1.5%. However, in September this will fall to 0.9% (RPI inflation).
- 2012 loans: Although no graduates will be repaying this loan until next year, it’s worth mentioning for comparison. The interest rate is RPI if you earn less than £21,000 rising slowly up to RPI + 3% if you earn over £41,000.
If you want more information on student loan types, repayment schedules and interest rates, here is the government website:
Standard Student Loan Repayment (1998 – 2011 loans)
We’ll focus on this type of loan for the repayment example, as there are currently 3.5 million outstanding student loans of this type, compared to only 0.3 million pre 1998 loans.
As you probably already know, repayment is based on your income. An employee will pay 9% of everything they earn above £17,335 per annum. This will be taken automatically from your salary.
As an example, we will use the information provided by Tony, who also asked a recent question regarding saving in a (personal) pension compared to an ISA, which is definitely worth checking out:
Tony is in the following situation:
- A 24 year-old trainee accountant
- £10,500 in student loan debt
- Current salary of around £21,000
Therefore, in the coming year (September 2015 – 2016), Tony will incur interest on his loan of £94.50 (0.9% x £10,500) and make repayments of £329.85 (9% x (£21,000 – £17,335)).
Assuming a 5% annual salary increase and a usual repayment interest of 3% per annum for all subsequent years (the current 0.9% is very low), it would take Tony 13 years to pay back his student loan debt. Hopefully these assumptions will hold true, despite the recent trends in real wages:
For many people (Tony included), having student loan debt hanging over you for 13 years doesn’t seem like a great thing. Therefore, you may be keen to contribute extra to your balance in order to pay back your student loan early.
However, it’s important that we look beyond this and examine the alternatives in detail.
Student Loan Repayment – Potential Arbitrage
No, not the film!
The term “arbitrage” is an important one in finance, and in personal finance, but it is not known (or understood) by that many people. It is defined as:
“…the practice of taking advantage of a price difference between two or more markets.”
One primitive, and fairly unlikely, example may be that in a game of heads and tails, one person offers you £2.10 if you bet £1 on heads and another person offers you £2.10 if you bet £1 on tails. You could be on both (£2) and be guaranteed £0.10 profit.
Another example is the practice of stoozing. This is where you take out 0% credit cards and save/invest the money elsewhere at higher returns. This is actually something that I currently do and you can find out more information about it here:
A much more relevant example is the following. Imagine that someone will lend you £10,500 at 0.9% interest for the year.
Santander 123 account offers a 3% savings rate, which equates to 2.4% after basic rate income tax. Therefore, someone else is guaranteeing you 2.4% fixed interest in you invest your money in their account.
So, if Tony had £10,500 today, he could either be:
- Paying back his student loan in full and avoid £94.50 in interest in the next year
- Leaving his student loan paying the minimum, incur £94.50 interest, but place the £10,500 into the Santander account and earn 2.4% interest (equating to £252). So, through arbitrage, Tony has earned more than an additional £150!
Arbitrage Equivalents – Fixed Rate
The key to the equation is to work out what the interest rate is on the loan compared to the alternatives, and then place you money into what you consider the best alternative. In the current low interest rate and low inflation rate environment, there will usually be a better solution financially than paying back your student loan.
The first set of equivalents when determining if you should be paying back your student loan are what I would describe as “exact equivalents”. The key with these is that the return you receive on your cash is fixed.
With this, you know that you will be paying 0.9% interest on your student loan. Therefore, if you can guarantee a fixed rate of more than 0.9% for the next year, you are better off not making any overpayments on your student loan.
Some current examples, accurate at the time of writing are:
- Easy Access Cash ISA (Virgin): 1.51% (no tax)
- Easy Access Cash ISA (NS&I): 1.5% (no tax)
- 1 year fixed rate ISA (Shawbrook Bank): 1.75% (no tax)
- 2 year fixed rate ISA (Coventry BS): 2% (no tax)
- Saving account (Santander): 3% (pre-tax)
- 1 year fixed saving (Nationwide): 5% (pre-tax)
- 1 year fixed bond (Charter): 2.15% (pre-tax)
Arbitrage Equivalents – Variable Rates
You can see that the fixed returns that you can earn instead of paying extra on your student loan means it’s current beneficial to be holding back on making overpayments on your student loan.
If you are willing to take a little more risk and look at non-guaranteed rates of return, then your returns elsewhere could become even more appealing.
For instance peer-to-peer lending average rates with Zopa are currently 5% (pre-tax). A little more variable are FTSE 100 historical annual returns including dividends at 8-10% (with no tax if saved in pension / ISA). Alternatively, investments in real estate could return even greater returns (but with higher risk):
These variable returns could lead to losses in any one particular year, so you have to think about the long-term averages and EV to make your decision, but ensure that you can deal with the blow if any one year turns out to be a disaster.
Think About Other Borrowing
This is an important thing to think about for the vast majority of graduates and will usually answer your question straight away (it certainly will for Tony).
Tony told me that he has £20,000 saved up as a deposit for a house and intends to buy in the next year or so.
Therefore, he’ll be taking out a mortgage and Standard Variable Mortgage rates tend to be at around 2% above the Bank of England base rate.
However, remember that the student loan interest rate for 1998-2011 loans is THE LOWER of:
- 1% above the Bank of England base rate; OR
- RPI for the prior year
So, if Tony (or you) were to repay your student loan and then take out a mortgage, then you are effectively just swapping a cheap form of borrowing for a more expensive one.
What About Risk With Student Loan Repayment?
Many advocates of paying back debt cite “risk” as a non-quantifiable factor which means that you should ALWAYS pay down debt. Whilst I agree that risk certainly needs to be considered in this way, the inclusion of this factor into our analysis actually cements our decision not to pay down our student loans.
Firstly, and most importantly, if we lose our job and corresponding income, the repayment obligation on the student loan stops (when we earn less than £17,335 per annum). The same is not true of most other forms of debt.
Also, keeping cash in savings which we can access in the short term (cash savings or S&S ISA for example) means that we are better equipped in the case of an emergency. If you use your extra income to pay back your student loan, the only way of getting that cash back is to take out a new, more expensive and less flexible loan.
A Real & Important Example Why You Shouldn’t Be Paying Back Student Loan Early
Let’s build on Tony’s example a little to show you the potential cost of repaying your student loan early. We’ll take the following assumptions:
- A 24 year-old trainee accountant
- £10,500 in student loan debt
- Lower payment limit to increase by 3% per annum
- Student loan interest estimated at 0.9% for next year, 2% for following year and 3% for all subsequent years
- Current salary of around £21,000
- Salary to increase at 5% per annum
- 8% long term average returns from FTSE 100s saved in pension
- Employer match of 5% of salary
Tony has two choices.
- Repay the standard amount of student loan and overpay his student loan with 5% of his gross salary
- Repay the standard amount of student loan and contribute 5% of his salary to his pension which will be matched by his employer and then invested in a low cost FTSE 100 tracking ETF
We’ll look at these two examples separately from today until Tony theoretically retires at the age of 58 and then compare at the end…
Student Loan Repayment – Paying Back Student Loans Early – Scenario 1: Yes
Tony earns £21,000 this year.
In year 1, he repays (£21,000 – £17,335) x 9% as his standard payment = £330. He also contributes another 5% of his gross salary to paying back his student loan = £1,050. His incurred interest for the year is £95.
In year 2, he repays (£22,050 – £17,855) x 9% as his standard payment = £378. He also contributes another 5% of his gross salary to paying back his student loan = £1,103. His incurred interest for the year is £184.
This continues until he has fully repaid his student loan. At this time, the standard repayment and additional repayment will both be placed into the company pension. This means that they will earn 20% government tax credit for contributing pre-tax.
Also, Tony will earn the 5% employer match, and earning 8% annual returns.
All this information is summarized in the “Scenario 1: Yes” tab of the following spreadsheet:
In conclusion, upon retirement, Tony will have a pot of £582,405.
Student Loan Repayment – Paying Back Student Loans Early – Scenario 2: No
Same scenario: Tony still earns £21,000 this year.
In year 1, he repays (£21,000 – £17,335) x 9% as his standard payment = £330. He then contributes 5% of his gross salary to his pension, which is matched by his employer and earns 8% annual returns.
This continues until he has fully repaid his student loan. At this time, the standard repayment is also added to his pension, but is not matched by his employer.
All this information is summarized in the “Scenario 1: No” tab of the following spreadsheet:
In conclusion, upon retirement, Tony will have a pot of £692,004.
Student Loan Repayment – Paying Back Student Loans Early Could Cost £100k
When we make the comparison of the final pension pot, we notice that if we paid down our student loan debt earlier (which we would have done thinking that we were making a good and responsible financial decision), we will be almost £110,000 worse off when hitting retirement.
It’s these monumental figures in the long-term which ensures that we NEED to take the time today to think about these things before acting on generic advice we may have had from our parents, other colleagues or from the general media.
Student Loan Repayment – One last consideration…
One final factor to remember is that student loans only have a finite life – they are wiped clean at a certain age. Again, this is not like any other form of debt. When the debt is forgiven varies, but it’s generally between 25 and 33 years after you graduate.
In Tony’s example, this doesn’t have any relevance as even with paying the minimum he would repay his loans within 16 years.
However, if your numbers and projections are different, then maybe you may be repaying some debt that you don’t need to.
Also, if the worst was to happen and you were to unfortunately pass away during this time, you would be paying back your student loan when this money could have been passed onto your loved ones when your student loan debt was forgiven.
Should I be Paying Back Student Loans Early? – Our conclusion
Is paying back student loans early a good idea?
In almost all cases, NO!
You could earn better returns elsewhere, you will probably take out other loans (e.g. mortgages) on less favorable terms and student loans (for 1998-2011 loans) only ever incur interest at low inflation or just above the Bank of England base rate.
I’d encourage you to mess around a little with the spreadsheets to use your own salary, assumptions on returns and inflation, your own employer pension scheme or other tax incentive schemes, etc in order to find your own “retirement figure”. However, I can assure you that you’ll struggle to make scenario 1 of paying back your student loan look better than the alternative of scenario 2.
If you want to discuss your student loan repayment scenario, or have any questions about this post, please leave a comment below or send us an email to discuss. It would be great to hear from you.