Student Loans: why overpaying could mean throwing money away
The Student Loans Company has just revealed the new interest rate on loans from 1 September 2018, and as expected the headline rate has risen to 6.3%. It’s calculated by adding 3% to the March 2018 RPI inflation rate, which was 3.3%.
But before you panic about trying to overpay a loan with an interest rate that’s considerably higher than most mortgages and other borrowing, there are some things you need to know – because everything is not always as clear it seems.
Most students will never repay their loans, so the interest rate is irrelevant
The Institute for Fiscal Studies estimates that up to 80% of this year’s students will not repay their loans in full, because they’ll never earn enough before the 30-year loan term is up.
The Institute notes that the Department for Education’s accounts show that of the £14bn-worth of student loans given this year, around £6bn-£7bn will be written off in future. That’s because…
1. You’re no longer liable for your student loans after 30 years
You’re liable for student loan repayments until the earlier of one of three things happens:
- You reach 30 years from the April after graduation
- You repay your loans and interest in full
- You pass away
After 30 years (if your loan is from 2012 or later), your loan is wiped, regardless of whether you’ve paid some or even any of it back.
I’m a big believer in the psychology of money, and it’s this aspect that is more important for the vast majority of students – having a large loan against their name for up to three decades.
Rather than consider the whole amount, which seems too big to ever clear, think of your repayments as a form of graduate tax, which is no different than any other tax you’ll pay in your working life.
2. Repayments only start at a certain level of income
Student loan repayments start from the April after graduation, and only when you earn more than £25,725 in a year (known as the repayment threshold, and set to rise in line with average earnings in future years).
At this annual income level, the interest rate is 3.3%; it rises on a sliding scale up to an income of £46,305, at which point interest is charged at the headline 6.3% rate.
You might not plan on earning below the national average, but because a proportion of graduates never earn more than the repayment threshold, you may never pay a penny of your loans back.
The repayment threshold has risen from £25,000 last year, which means repayments will actually fall for some graduates. However, it’s worth noting that this will be counterbalanced by the rise in automatic enrolment pension contributions, which increased to 3% of salary in April and will go up again to 5% of salary in April 2019.
Your annual repayments are the same regardless of how much you owe or the interest rate
You will pay 9% of your income above the current repayment threshold of £25,725 in student loan repayments, which means that the amount you owe has no impact on what you pay back annually.
If you earn £50,000 a year then your annual repayments will amount to 9% of £24,275, which is £2,184.75. This is true whether your loans and interest amounts to £20,000, £60,000, or anything in between (or above).
It’s your income that determines your annual repayments, not how much you owe.
Should you overpay your loan?
There’s no clear-cut answer to this question, because you have to make assumptions on your income over the next 30 years to know – but for many, the answer is absolutely not. Let’s use three earnings examples to highlight why:
- If you never earn over the national average, you’ll never pay a penny of your loan back, so overpaying would be literally throwing money down the drain.
- If you earn around £35,725 consistently over 30 years, even if the repayment threshold and national average wage stayed at their current levels (which they won’t of course), you’d end up paying back £900 each year (9% of the £10,000 you earn over the repayment threshold). Over the course of 30 years, that would amount to £27,000 repaid before your loan is wiped.
Suppose you had £15,000 in savings that you decide to overpay now – and remember, that won’t change your repayments at all, only your income does that – then if your outstanding loan is more than £27,000 + £15,000 (and the average student loans owed amount to around £50,000), you’ve given your £15,000 away for no reason if you overpay.
- If you think you’ll earn £45,000+ consistently for the next 30 years, then overpaying is something you should consider, because you’re likely to save money in the long-term – you’ll be one of the 20% or so that eventually repays their entire loan plus interest. I discuss the best ways to overpay debts in my book, The Money Plan.
However, if you have other unsecured debts, then you should pay those down first. Your student loan does not affect your credit score, and if you might not be a high-earner for all of the next 30 years – you might take a career break to start a family or travel for example – then you may not benefit as much from overpaying your student loans.