Should I Pay Off My Student Loan?
This post is for those who attended university in the United Kingdom and have a student loan in pounds sterling that they’re questioning whether to pay off. We don’t know what the loan arrangements are in other countries, but this post could still be useful if you have a student loan outside the UK.
Before diving into this post, it’s worth us summarising for those short on time.
Question: Should I Pay Off My Student Loan?
Short Answer: No.
Long Answer: Probably Not, but it depends how much you earn.
In the UK, there are two current undergraduate student loan plans. Plan 1 loans are for students who commenced university between 1998 and 2012. Plan 2 loans are for anyone taking out a loan after 1st September 2012. The transition to Plan 2 loans coincided with a steep increase in fees from approx £4k/year to £9k per year.
If you have a student loan, you’ll know that it’s a combination of your course costs and also any maintenance/living expenses loans you were eligible for. We assume that at this point, you’re aware of your current loan balance and questioning whether to pay off more than what is taken from your monthly salary?
Plan 1 Student Loans
If you’re on a Plan 1 loan, first of all, congratulations at going to university before the fee increase. Under Plan 1 loans, the threshold for paying back your loan is £1,615/month. 9% of anything earned over this amount is deducted from your pay slip.
The most important thing to consider is the interest rate on the money you owe. Interest on Plan 1 loans is charges at either the Retail Price Index or the Bank of England base rate plus 1%, whichever is lower. At the time of this article that puts the interest rate at 1.1%. This is less than inflation.
If you’re thinking about paying off your loan, look at the interest rate and first of all think, am I paying off any debts at a higher interest rate? This could be credit card debts, car payments or a mortgage for example. The interest rate on all these debts is likely to be higher than 1.1%. If so, don’t pay off your student loan. Take the money you would use to pay it down and pay off those debts first.
OK, so you’re doing well and don’t have any other debts to pay down. In that case, you might be thinking that the next thing to do is pay down your student loan. However, think about what return you could get on the money you would use to pay down the loan. If you put that money into a savings account, sure you might not get 1.1%, but you’d get some kind of return. Banks like First Direct are still offering Regular Savings accounts paying over 2% interest, so you’re actually profiting by putting the money into such an account. You also have the advantage of having a pot of money available should you need access to the cash in the future.
Alternatively, you could invest the money into a wide variety of things. You could invest in the stock and bond markets, use the money to start a business, peer to peer loans etc. etc. There are numerous methods out there to potentially earn over 1.1% on your money, although of course some of these come with risk of losing money.
The point is, an interest rate of 1.1% is nothing. It’s barely noticeable. You’re much better off having the cash in hand or investing it somewhere that will pay you a higher return. This is the cheapest loan you will ever get.
Plan 2 Student Loans
Under Plan 2 loans, the threshold for paying back your loan is £2,214/month. 9% of anything earned over this amount is deducted from your pay slip.
The BIG difference under a Plan 2 loan is the rate of interest you pay. While you’re still studying, the interest rate is charged at Retail Price Index + 3%, with the interest rate for the year being set on the 1st September for the following year. Since 2012 the average interest rate has been 5.6%.
After you finish studying, the interest rate depends on your annual income.
| Your annual income | Interest rate |
|---|---|
| £26,575 or less | RPI (currently 2.4%) |
| £26,576 to £47,835 | RPI (currently 2.4%), plus up to 3% |
| Over £47,835 | RPI (currently 2.4%), plus 3% |
From the above it’s clear under Plan 2 you’re paying a significant amount more in interest than those under Plan 1. In deciding whether to pay down the loan, you will need to consider your current and future earnings potential.
If you earn under under the threshold for repayment of £26,568/month then you currently aren’t seeing any deductions to your monthly pay. In the background, however, the amount you owe is growing larger and larger every month. At this point you have to be honest with yourself and contemplate what you might earn over the next 30 years. Plan 2 loans get written off after 30 years if you haven’t repaid them.
If you’re only going to earn £25-£30k per year for the next 30 years then don’t pay off the loan. You’re better off just paying the deduction at 9% on your salary for any earnings over the threshold, and in 30 years the balance will be written off. If you’re a higher earner then you’ll need to look how much much you’re earning and run some calculations. Everyones’ situation is different.
A quick way of thinking about it is to forecast your expected earnings potential over the next 30 years. Assume you start at your current salary and will, for example, get a £5k pay rise for the first 10 years, then a £2k pay rise for the next 10 years and so on. This depends on your industry, but you get the idea. Then figure out the average figure you will earn each year.
Deduct the threshold of £26,568 from this figure and then multiply the difference by 9%. This will show you how much you will pay back on average per year as deductions from your monthly pay, assuming you don’t clear the balance of your loan in that duration. The more you earn, the more likely it is you’re going to repay the loan by the end of the 30 year period.
If the figure calculated above exceeds the amount you expect to pay in interest over the next 30 years then we suggest starting to pay the loan down now, assuming you don’t have any debt which attracts a higher interest repayment. If you don’t have credit card debt and you’re only payment is a mortgage you’re likely not paying more than 5.6% interest. Sure you can get a higher return in the stock market, but that’s not a risk free return. Money paid of your loan nets you a 5.6% return risk free.
Only start repaying the loan if you’re sure you would repay it within 30 years anyway. If you forecast you would repay it in 25 years, then bringing forward payments will reduce the amount of interest you pay (that compounds over time – i.e. you pay interest on interest). This will result in the loan balance being cleared earlier (possibly many years earlier depending on how much extra you repay). What you’re doing here is investing for the future. You looking ahead to those years where, without early repayments, you’d still be seeing a deduction to your monthly pay. Instead, you won’t get this deduction and you’ll be getting paid extra money each month instead.
If you need to keep the cash free for spending now then you have the option of not repaying. This essentially amounts to a long term loan at 5.6%. You’re potentially better off taking out a loan at say 3% and using the money to pay down some student debt. The problem is, loans tend to be repaid over a 3-5 year period whereas you’re student loan is over a couple of decades. Again, it depends on your circumstances and where you are with your repayments as to whether this is a good option for you.
Should I Pay Off My Student Loan – To Summarise
Hopefully the above provides some guidance on what you need to think about when considering if you should pay off your student loan. While we can’t give an answer for everyone as it depends on your circumstance, the above sets out the fundamentals in question. If you’re on a Plan 1 loan, then in most cases it’s not worth paying off the loan early with interest rates at their current levels.
If you’re on a Plan 2 loan, then it depends on your future earnings potential. Lower earners are better off repaying the minimum from their pay each month and writing off the loan after 30 years. Higher earners might get a benefit out of paying off the loan early to avoid repaying additional interest accrued for compounding. Middle earners have the most difficult decision to make as it’s a fine balance between simply paying the minimum or trying to pay off the full loan early.
If you want any further guidance on this, please sign up to our newsletter where we can provide some further advice to suit your specific situation. You might also find our post on Building Your Own Balance Sheet useful, as before you think about repaying your student loan you need to have a clear view of what other debts you have.