Issue 102:2017 04 27:Graduates of the UK unite! (Frank O’Nomics)

27 April 2017

Graduates of the UK unite!

Repay student loans by whatever means possible.

By Frank O’Nomics

Are student loans the latest financial product to be mis-sold?  Those who thought they were borrowing cheap money to finance their university education are in for a big shock this September when, for some, the interest rate they pay on the debt will rise to 6.1%.  This is hardly cheap money when it is possible to get a fixed rate mortgage for 2yrs at just over 1% (APRC 3.4%), and even the average standard variable rate is currently only 4.59%.  Given that it is highly unlikely that bringing a case of mis-selling against the Department for Education will provide any joy, the question is: what should graduates do about this expensive millstone?

First some further harsh facts.  Student loans carry an interest rate of RPI until a graduate earns £21,000 and thereafter there is a sliding scale until earnings exceed £41,000, when the interest rate is RPI +3%.  The RPI used to set this level is that for March, which was 3.1% this year, hence the higher rate band of 6.1% (up from 4.6%) from September.  The indexing of debt starts from the point at which the loan is taken out, so students suffer from a debt increasing (arguably at a rate greater than the cost of living) for at least 3 years before they start their careers.  Quite why RPI, rather than CPI, was chosen is interesting, given that, typically, CPI is 0.7% lower than RPI (it is currently 0.8% lower).  On a compound basis this makes a big difference, and is at odds with the fact that CPI is used to index benefits such as pensions under the “triple-lock”.  It would seem that the choice of index is carefully selected to the advantage of the government.  Further, it was expected that the trigger salary for starting repayments would rise with inflation, but the £21,000 was frozen for 5 years in 2015, so there will be no respite until 2020.  The Department for Education points out that repayments are fixed at 9% of the excess in pay over £21,000, so there is no cost of living impact on graduates, but the point is that it will take them longer to pay off their debts as RPI (plus up to 3%) continues to increase them.

The average student debt incurred by students in England and Wales is £44,000.  Repayments on debts of this size will reduce scope for building savings for contingencies or a deposit for a home purchase, let alone putting anything into a pensions plan.  In looking at what can be done to address this issue we can probably rule out that of not taking out the loans in the first place – few will be able to afford to self-fund through university; and moving to Scotland (where university fees are paid for by the Scottish government for Scottish residents) might be an extreme measure for many.  One alternative is to pay off as much of the debt as you can afford sooner, rather than just at the 9% level set by the government.  Graduates should ask themselves whether they are confident of finding a better return for their money than 6.1%.  Many saving products have consistently beaten this rate of return, but there are clearly timing, and fund selection risks associated with investing to build a sum to repay the debt in the future.

One alternative solution is to borrow the money to repay the debt. The danger here is that you are just swapping one loan for another and, while you may be able to negotiate a rate better than 6.1% the benefits could be fleeting if inflation falls or interest rates rise. The big difference comes if you can borrow the money from a relative – more commonly known as the bank of mum and dad.  Current interest rates on deposits are very low and even if one achieves 0.5%, that still leaves the cost of student debt some 24 times higher.  If parents have sums in low interest bearing savings accounts, lending them to their children would seem to have little opportunity cost.  Graduates can use the money to repay student loans and then either repay their parents gradually over time, or start a savings plan to build up a sum to repay the whole amount at a point in the future.  With this route the investment plan looks more interesting.  The average annual return on some investment trusts over the last 25 years have been as much as 9%.  The prospect of this kind of return leads to the possibility of repaying the loan from your parents far more quickly than you would the student loan, or having an excess amount that can be used for a house purchase or a pension plan.  There are clearly two issues with this approach; first, you need someone who has the funds to lend, and secondly, both parties need to be aware that there will be risks that the investments do not deliver the returns as quickly as they have previously.

These are not the only possibilities of course.  The problem goes away if young people decide not to go to university – and there is justifiable concern that, once graduates are hit with the new interest rates in September, many prospective students will look for work instead.  Secondly, student debts are written off after 30 years.  Those earning less than £21,000 will pay nothing, but even those who currently earn around £29,000 will still not have paid off all of their debt by the time 30 years are up.  That itself is a sobering statistic, given that £29,000 is above current average earnings.

What are the prospects for change? Ultimately the £21,000 should be indexed, and there is a strong argument for shifting the index for repayments to CPI, but the millstone that Mike Wilson of Henderson described as “the silent killer of savings, spending and hope” looks set to dog the millennial generation for a lifetime – unless they find a way of repaying it early.

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