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Student loans are set to get more expensive – should you pay them off as soon as possible?
Chancellor Rishi Sunak has announced a shake up of the student loan system, which will make it more expensive for people to go to university and mean graduates are paying off their loans for up to 40 years after they leave university.
Graduates and potentially their parents may be left wondering if there’s a case for taking action to pay off borrowings as early as possible in light of these changes.
The modified rules extend the period until your loan is wiped out from the current 30 years up to 40 years. It means someone who graduates when they are 21 could be paying off their loan until they are 61.
The next big change is that the threshold at which you start repaying your loan has reduced from the current £27,295 down to £25,000. However, one help for graduates is that the interest on the loan will be simplified to be just the current rate of RPI inflation, where currently it’s charged at RPI plus up to 3%, varying by your income.
REPAYMENTS GOING UP
However, the combined impact of these changes mean that many graduates will repay more than double what they currently do. For example, someone who graduates with £45,000 of debt on a starting salary of £30,000 a year will currently pay back £30,900 in total, assuming their salary increases by 3% a year. Under the new system they will repay £71,518 – so almost £27,000 more than they borrowed thanks to the impact of interest over the 40-year term of the loan.
Someone who starts on a lower graduate salary of £20,000 will pay back £7,207 under the new system, whereas previously they wouldn’t have repaid any of the loan as they would never have earned enough to get over the income repayment threshold.
However, the changes do benefit higher earners, who will pay off their loan faster and so incur less interest over the term of the loan, but also benefit from the lower, flat-rate interest under the new system. For example, someone on a starting salary of £50,000 (on the same debt and salary increase basis as above) would pay off almost £117,000 under the current system, but only £62,000 under the new system. Of course, few graduates will start on such a high salary.
SO IS IT BETTER TO PAY OFF THE LOAN STRAIGHT AWAY?
Parents who have a lump sum they could use to pay off the debt will now be wondering whether it’s better to pay off the loan as soon as their child graduates (or just not take out the loan in the first place and use that pot of money to pay for their child’s university education) or whether they leave their child to pay off the loan through their salary. However, it’s not an easy calculation and relies on some big assumptions about your child’s future earning potential.
The first thing to note is that student loan debt is not the same as other debt – you don’t have to pay it if you have no income, or your income falls below the new £25,000 a year threshold. So, if you take time out, a career break or work part-time on a lower salary, you wouldn’t be liable to pay it. It also doesn’t count on your credit file as debt like that volume of credit card debt would, for example.
Regardless, many graduates won’t want their university debt following them around for 40 years if they can help it. And, as you repay your debt at a rate of 9% of any income over the £25,000 threshold it means that graduates have a 42.25% effective tax rate over this income level (20% basic rate tax, 13.25% National Insurance and 9% student loan repayments). That could significantly impact their ability to save money for a house deposit, for example, or to live the lifestyle they want.
However, whether it’s worth paying off the loan hinges on what your child is likely to earn. Someone with £45,000 of debt on a starting salary of £25,000 who sees a steady 3% a year increase in their salary will repay just over £36,000 in total over the 40 years. That’s obviously much less than the amount they initially borrowed and so means it wouldn’t be worth paying off the debt when they graduate. However, a small increase in their starting salary to £30,000 changes the figures entirely, as they would pay off just over £71,500, far more than the initial debt.
ACCOUNTING FOR PERSONAL CIRCUMSTANCES
These scenarios don’t account for any career breaks, due to having children, going back into education or travelling, where the graduate would make no repayments. And nor do they account for big increases in salary, due to promotions or switching jobs. And both these factors can dramatically impact the sums.
Let’s take that person starting on £30,000, with £45,000 of debt and a gradually rising salary. If they took a five-year career break early on in their career and then resumed work on their previous salary their repayments will reduce to just more than £40,000.
Now take that same individual starting on £30,000 with no career break but instead they get three pay rises of £5,000 each in years five, 10 and 15 of their career – now their repayments rocket to almost £104,000 – meaning that it would have made financial sense to pay off the loan when they graduated.
As these figures highlight, there’s no easy answer. Some of it will come down to the career your child picks and their likely future choices around career breaks, and some may come down to whether that’s the best use of the lump sum you have sitting around.