For most of us, the concept of debt is as a sum that is borrowed and then repaid as soon as possible. However, while that might be the case for regular finance, student loans are rather different. As a result of the very specific terms and conditions that come with student loans, for some people, it may actually make more financial sense not to repay student loans. So, how does it work?
What type of student loan have you got?
This is the first essential question. Depending on when you went to university you will have a different type of loan and alternative rates of interest and repayment might apply.
Pre-1998 student loans. The interest rate is set each year based on the rate of Retail Prices Index (RPI) inflation – as of September 2019 it was 2.4%. Repayment is a requirement for anyone earning more than £32,347 a year.
1998 – 2011 student loans. These are known as ‘Plan 1’ Loans and the interest rate is the lower of the rate of inflation or the Bank of England base rate, plus 1%. Currently, it is 1.75%. As soon as you earn £18,935 a year (£19,390 from 6 April 2020) you have to repay 9% of what you earn above the threshold e.g. repayment on a £20k salary would currently be £96 a year.
2012 and beyond student loans. These are ‘Plan 2’ Loans and have a much higher interest rate – 5.4% (reduced from 6.3% as of September 2019). Repayment is required at 9% of what you earn above £25,725.
Are there any benefits to repaying your student loan?
First of all it’s worth noting that most student loan repayments will be automatically deducted from your salary once you go over the specific threshold for your type of loan. So, you will not have any choice about making the basic repayments. What many students are currently struggling with is the question of whether they should overpay on a loan – or pay it off completely if they have the cash. The short answer to that is, unless you are earning more than £50,000 a year, you’re otherwise debt free and you’re not likely to want to get on the housing ladder any time soon there may not be any financial benefit to you in committing to total repayment. Here’s why:
If you’re on Plan 1 or Plan 2 then what you owe doesn’t impact on your repayment size – this is based on what you earn. Your student loan could be £5,000, £50,000 or £500,000 (unlikely but just for demonstration purposes) and you would still be making the same repayments – 9% of whatever you earn over the relevant threshold.
Depending on the type of loan you might be paying little, or nothing, to just sit on it. So, for Plan 1 the cost of borrowing is the Bank of England base rate plus 1% or just the rate of inflation – whichever is lowest. This means that, effectively, the loan costs nothing to borrow because you’re only repaying the rate of inflation. For Plan 2 loans the rate is higher but still lower than the interest rates of most high street lenders.
The loan will eventually be wiped. Even if you haven’t repaid anything at all, your debt will just disappear. Anyone graduating before 2005/2006 will have their loan wiped at 65. For post 2006 graduates it’s 25 years from the first April after graduation. For Plan 2 loans this happens in the April, 30 years after you graduated. According to the Institute For Fiscal Studies 83% of English student loan holders won’t clear their debt within 30 years and so will have it wiped.
What should you do instead?
Rather than trying to clear such low interest debt that is going to disappear at some point anyway it makes sense for many people to invest extra cash elsewhere. For example, you might have credit cards or other debts from your student days that are smaller but have higher interest rates. So clearing other debt should be more of a priority than overpaying on student loans. Putting money aside into savings can also be more constructive than sending it to your student loans lender. If you’re lucky you might find a savings interest rate that is higher than what you’re paying for student loans. But you can also create some security by putting that additional money aside for a rainy day.
For many people, working to overpay or fully repay student loans as soon as possible just to be debt free just isn’t financially smart. Rather than worrying about having that debt hanging over you it may well make sense to use the extra money in a different way to help secure your financial future.