This content is for information and inspiration purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice regarding your affairs please consult us here at WMM.
It’s natural to think of debt as a terrible thing which should be eradicated as quickly as possible. So when young people are asked whether their student loan should be paid off early (perhaps using a lump sum from an inheritance), many automatically assume they should do so. Yet is this really the wisest use of your money?
Here at WMM, as financial planners in Oxfordshire, we are often confronted with this sort of question, and our answer may surprise you. For most people, paying off their student loan early is not a sensible financial decision. Whilst there will be exceptions, of course, in the majority of cases you will likely find a better use for your money with the help of an experienced financial adviser.
This article explains our thinking on this subject. Please consult us before making any big decisions regarding your investments, or a large inheritance lump sum.
Why UK student debt is different
When you take out a personal loan with a bank, it’s not uncommon for the APR to stand at 20% and for debts to consequently spiral out of control. A £1,000 debt can soon become a far larger liability after a short period of missing or underpaying the commitment. This sort of debt can severely hamper your ability to save and invest, draining your monthly income. Having a sensible plan to clear it as soon as possible is, therefore, usually a very good idea.
Student debt is different, however. In 2019-20, here is a brief summary of distinct areas:
- Linked to earnings. When you take out a personal loan with the bank, you are obliged to pay it back regardless of your income. With a student loan, however, you only start paying it back once you attain a certain level of income. Under the new rules in 2019-20, you need to repay 9% of your earnings once your salary exceeds £25,725 a year. As an example, if you earn £33,000 a year you are likely to repay £54 per month. If you earn £21,000 per year, however, then you would repay nothing in that tax year.
- Expiry date. Most personal loans do not have a termination date, which is why they can create such vast levels of debt if they remain unpaid. Most undergraduate student loans, on the other hand, have a 30-year repayment period. If you do not repay the full amount you owe within this period, then the remaining debt is wiped out.
Interest. Credit cards in 2020 commonly now involve a 20% APR. Post-2012 student loans, however, have a 5.4% interest rate.
Don’t waste your inheritance
Many people panic when they learn about the 5.4% interest on post-2012 student loans. After all, this exceeds most monthly mortgage rates! However, it’s important to put this into perspective. As a general rule, unless you are a very high earner with no debts (and no plans to take out any loans or mortgages), then overpaying your student loan with an inheritance or other lump sum is unlikely to be in your best interests.
There are two crucial things to bear in mind here. First of all, the interest added to your debt isn’t what determines what you pay each month. Yes, if you have recently left university with as much as £40,000-worth of debt, you might well have already accrued £4,000 interest or more after one year from graduation. Yet this doesn’t mean your monthly repayments are going to go up, as they would with a personal loan. Your income is what determines your repayments.
Secondly, the student debt will be wiped after 30 years. Therefore, you could argue that your monthly repayments should be seen as a kind of time-limited “graduate tax”. The more you earn, the more you repay. However, if you never earn over £25,725 a year throughout your career, then you may never have to commit even a pound towards repayment. Therefore, what ultimately matters is that you can meet your monthly student loan repayments – not that you wipe out the debt as soon as possible.
Things to consider with an adviser
Of course, there are still situations where certain people might do better to repay their student loan early (perhaps with the help of a recent inheritance). Here are some questions to consider with a financial adviser, to help determine the right course for your own situation:
- Could an investment portfolio beat your student loan? At best, interest on student loans stands at around 2.4%, and 5.4% at its worst. A well-constructed investment portfolio, however, could realistically provide returns which, on average (year-by-year), exceed the interest on your student loan repayments.
- Do you have other expensive debts to clear first? Since credit cards can charge 20% APR and the debt has no time limit, you’d likely be better-off focusing on clearing these immediate debts which threaten your financial stability, than your student loan.
- How certain are you about the future? The interest rate added to your student debt is actually linked to your earnings. So, unless you’re starting a career on about £45,000 per year, you’re unlikely to be near the top 5.4% interest rate. Those earning this kind of income and above throughout their career might possibly be better-off repaying their student debt early. However, if you’re unlikely to earn these kinds of figures in the near future (and are uncertain about the long term), then early repayment is less likely to make a big difference to your wealth and income.
Invitation
If you are interested in starting a conversation about your financial plan, then we’d love to hear from you. Get in touch today to arrange a free, no-commitment consultation with a member of our friendly team here at WMM.
Reach us via: 01869 331469
