If you can, should you prepay a student loan?
Many parents want to help their children finance their college education, but this may not be the best use of financial support. In fact, those who pay tuition or pay off student loans may simply subsidize other taxpayers. Their money could be better spent on other priorities. Who is eligible for early repayment of their loan and who should use their money for other purposes?
The confusion around student funding stems from the terminology used by the government and the Student loan company. Student loans are not like other debts, it is a tax on graduates that lasts for up to 30 years after graduation. Any loan not repaid by then is canceled. the Institute of Tax Studies calculates that less than 30% of student debt will be repaid in full, the rest is written off.
The interest rate charged on the loans depends on when the loan started. Before September 2012, the interest rate was 1% higher than the base rate of the Bank of England, so currently 1.1%. For loans from September 1, 2012 and postgraduate loans, the rate decreases from 0% to 3% plus RPI, the more you earn the higher the interest rate. The inflation factor is adjusted annually in September, based on the inflation for the previous March. Reimbursement starts from the month of April following graduation, but only when the pay threshold (see table) is exceeded.
Although the interest rate charged is added to the debt, it does not affect the amount the graduate deducted from their income. Repayment is based on the income of graduates above the threshold, with 9% of excess income (6% on postgraduate loans) collected through PAYE, or self-assessment. Until the entire loan is repaid, the graduate will not see any reduction in monthly repayments and will not receive any immediate cash benefit from the early partial repayment.
Table 1 – the terms of each loan plan
|Type of loan||Income threshold Â£||Deducted from income above the threshold||Interest rate|
|Plan 1 (before September 2012)||19 895||9%||Bank of England base + 1%|
|Plan 2 (after September 2012)||27,295||9%||Up to 3% + RPI|
|Postgraduate||21,000||6%||Up to 3% + RPI|
The compensation thresholds are revised each year based on inflation. When income is below the threshold, nothing is payable and the interest rate on post-2012 and postgraduate loans falls to RPI only. The refund amount is assessed at each payment point, so a one-time bonus will result in a larger reduction. Graduates whose income declines such that the income for the tax year is below the threshold can apply for a refund after the end of the tax year by contacting the Student Loan Company on 0300 100 0611.
Alternatives to repaying student loans
- Repay other loans such as credit cards, overdrafts, and sales credits, these will not be amortized.
- If you are saving for a first home and, if you are eligible for the ISA for life, up to Â£ 4,000 per year can be put into an account, to which the government adds 25% up to Â£ 1,000 per year.
- If an employer offers a retirement plan with matching contributions, supplementing retirement savings may be a better option. Personal contributions are tax relief and can be tax efficient up to Â£ 40,000 per year.
- Parents can save on a tax-free child care account, which represents up to Â£ 2,000 per year in taxpayer subsidy for each child under 12 to pay for registered child care.
To repay or not to repay?
The case studies below illustrate how the student loan program for loans after 2012 works. In all cases we assumed a loan of Â£ 58,686 upon graduation. We have assumed an average inflation of 2% and average profit increases of 2.5%, the actual rates and repayment amounts may be different, depending on the actual rates of inflation and earnings growth.
Graduated 1 a humanitarian worker, begins working with a salary of Â£ 19,000 per year, increasing by 2.5% per year thereafter.
No student loan is repaid because the income does not exceed the repayment threshold and the debt is written off after 30 years.
Graduate 2 a lawyer, starts working at Â£ 40,000 per year, increases 2.5% per annum then to Â£ 70,000 in 5th year and 2.5% per annum. after.
It will take 2 graduates 26 years to repay the loan if they only pay the amount required under the program, at a total cost of Â£ 114,924. Grad 2 maybe better to clear the loan sooner.
Graduating 3, an administrator starts working at Â£ 25,000 per year, increases to Â£ 40,000 after 2 years, increasing by 2.5% per annum, then quits the job 5 years later to start a family. They return to work part-time 19 years after graduation and earn Â£ 35,000 a year.
Graduate 3 repays Â£ 5,980 of the loan, their income does not exceed the income threshold when they return to work and after 30 years the debt is canceled. It is better that they pay only the minimum required each year.
Mortgage lenders consider any outstanding student loans to assess affordability based on the payroll deduction required by the current loan.
The suitability of early repayment of student loans depends on personal circumstances and future income trends. Taking a wait-and-see stance would make sense with only those who expect continually high income given early repayment.
Avoid student debt by saving in investment trusts