Many parents are keen to help their children fund their university education but this may not be the best use of financial support for their offspring. In fact, some parents who pay their child’s tuition fees or repay student loans may simply be subsidising other taxpayers. Their money might be better spent dealing with other priorities. Here we explain who can benefit by paying their loan off early and who should use their money in other ways.
The confusion around student finance arises from the terminology used by the Government and The Student Loan Company. Student loans are not like other debts, they are a graduate tax which lasts for up to 30 years post graduation. Any loan not repaid by then is cancelled. The Institute of Fiscal Studies calculates that only 30% of student debt will be repaid in full, the other 70% is written off.
The interest rate charged on loans depends upon when the loan was started. Before 2012 the interest rate is 1% over Bank of England Base rate, so currently 1.75%. For those who took their loan after September 2012, the rate is 3% plus RPI, so currently 6.1%, with the inflation element adjusted once a year. It is that very high interest rate which prompts many parents to assume that paying off student debt should be a greater priority than say, paying off a car loan or overdraft.
This is not necessarily the case as the interest rate charged, while adding to the debt, does not alter the amount which the graduate has to pay. Monthly repayment is based upon the earnings of the graduate with 9% of income over the repayment threshold collected through PAYE or self assessment for the self employed. Currently the income thresholds are £18,330 for pre 2012 loans and £25,000 for post 2012 loans. So unless the whole loan is repaid, the graduate will face the same monthly tax take from their salary based on 9% of earnings above the threshold.
Other loans such as overdrafts, credit cards, mortgages and car leasing schemes do not offer the option of cancellation after a given amount of time. Their cost also varies with fluctuating interest rates, so paying off these debts will usually be a better way to help the next generation than funding student fees or loans.
Alternatives to loan repayment
If the graduate wishes to save to buy a first home and is eligible for the Lifetime ISA, (under age 40) up to £4,000 per year may be paid into an account, to which the Government adds up to £1,000 per year. A payment into a LISA account may provide a better return than repaying student debt early. Alternatively if an employer offers a pension scheme with matching contributions, this too could provide a better option than repaying student debt as the personal contributions will usually qualify for tax relief at the marginal income tax rate. If made by salary sacrifice, this will also reduce the slice of income which exceeds the income threshold, saving an extra 9% in loan repayments. The employer contribution is also a tax free benefit up to the annual allowance for pensions savings, (up to £40,000 including personal contributions).
Whether paying back student loans early makes sense depends upon the personal circumstances and in particular future earnings patterns. For most graduates taking a wait and see position would be advisable, with only those who expect to have high earnings continuously for 30 years post graduation considering the early repayment option. The tables below compare 3 scenarios of future employment earnings patterns.
In all cases we have assumed that the student takes out the maximum fee and maintenance loan for students outside of London, leaving them with a debt of £56,878 on graduation. We have assumed average inflation of 2.76% and average earnings increases of 1.63%, the actual rates and repayment amounts may be different, depending on actual rates of inflation and earnings growth.
Graduate 1 Starts work on a salary of £17,000 pa, increasing by 2% pa thereafter
|Years to Reach Repayment Threshold||Montly Repayment||Debt Outstanding||Total Repaid||Loan Written Off|
Graduate 2 Starts work at £40,000 pa, increases to £67,070 5 years later and then by RPI inflation.
|Years to Reach Repayment Threshold||Montly Repayment||Debt Outstanding||Total Repaid||% of Original Loan Repaid|
|29 Years 8 Months||£478.70||£0||£131,625||231.41%|
Graduate 3 Starts work at £25,000, increases to £40,000 after 2 years, then leaves work 5 years later to start a family.
|Years to Reach Repayment Threshold||Montly Repayment||Debt Outstanding||Total Repaid||Loan Written Off||% of Original Loan Repaid|
|After 2 Years||£106.34||£64,004||£0|
|After 7 Years||£93.40||£78,053||£5,995||10.54%|
|After 30 Years||£0||£292,664||£5,995||£292,664||10.54%|
As can be seen only those who expect to have continuous career earnings at a high level are likely to pay back the whole of their debt.
The Government is reviewing the whole basis of student funding and until that is concluded, repaying early could be premature, in case some measures of relief are given to recent graduates, some of whom are paying a lot more for their education than earlier cohorts.
Director of Public Policy, LEBC
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