Money Mensch: Student loans: do your homework
Follow The JC on Twitter
The halcyon days of interest-free student loans have just ended. And this isn't all about fresh faced 20-year-olds - if you're one of the 3.7 million graduates who haven't cleared their debt yet, even from 20 years ago, beware.
Last month, the official student loan company interest rate was, at worst, interest-free, and some were even shrinking. Yet, from September 1, what you actually pay depends on when you started your studies.
Pre-1998 student loans
If you are one of 350,000 graduates who now have these over ten-year-old loans outstanding, then your rate has gone up a huge amount. You're now being charged a large 4.4 per cent interest because September's new rate depends strictly on the rate of inflation (RPI) in the previous March. In the prior year that was negative, so for a year you had loans shrinking by 0.4 per cent. Now you will pay this year's positive 4.4 per cent, ie, £440 per year per £10,000.
Post-1998 student loans
Now 1.5 per cent and could rise more, was 0 per cent. For the last year, the loan has been interest-free, but is now 1.5 per cent and could rise more even before September. This is because the rate you pay is rather complicatedly set at the lower of: Inflation at the prior March (4.4 per cent) or a measure similar to UK base rates (0.5 per cent), plus 1 percentage point. So, if you are one of the 3.3 million graduates with one of these loans outstanding, while it's currently 1.5 per cent or £150 per year per £10,000 of debt, if UK interest rates rise, so will the amount of interest you are paying, up to a maximum 4.4 per cent.
Should I pay off my student loan?
Now millions are paying interest, it is hardly surprising that I have been bombarded with emails from people with spare cash asking if they should use it to pay off all or part of their student loan. For most people, the answer is a firm no. To explain why, it is important to understand why technically there is no "real" cost to student loans, as the interest rate is only ever as high as the rate of inflation. Think of it like this: if you borrowed enough money to buy a hundred shopping trolleys' worth of goods, you will only ever have to repay roughly the cost of the same trolleys of goods because the cost of your loan rises in line with prices.
So while the actual amount of cash you have to repay is higher, student loan borrowing doesn't diminish your purchasing power in any way.
This means that while the interest rates may have jumped, they are still the cheapest long-term debt that you will ever be able to get. Consequently, it is worth carefully considering whether you should use spare cash to pay them off.
The correct answer depends on your exact circumstances:
Do you have other debts?
Clear your most expensive debts first. As student loans are such cheap long -term debt, you would be far better off clearing all other before it.
While this is obvious with credit cards at 18 per cent interest, it is trickier with super-cheap mortgages. Yet, remember, in the long run it is likely the mortgage will be more expensive. Depending on what penalties are payable, it is probably worth repaying some of your mortgage rather than the student loan.
The main exception to clearing other debts before student loans are 0 per cent credit cards, but, even here, when the 0 per cent rate ends, the APR rate will soar. So unless you are extremely savvy and using a technique called "stoozing" (see www.moneysavingexpert.com/stoozing), then you are probably best repaying credit card debts first.
Are you debt-free?
You may think that if you are debt-free, clearing the student loans a no brainer. Yet first consider whether you are planning to borrow elsewhere in the future. If so, it doesn't make sense to pay off your student loan now only to reborrow money again using commercial debt at like a mortgage or personal loan at much higher interest rate. You would be far better off putting your money aside in a top savings account. Then, when the time comes, use those savings to reduce the amount you need to borrow using a more expensive form of debt. It is also worth remembering that student loan debt (with the technical exception of you defaulting on a pre-1998 loan) doesn't get listed on your credit file so won't affect your credit rating.
Debt free and you will never need borrow again?
Now you really may be convinced there is no reason not to pay off your student loan. Well, if you are one of those on the old 4.4 per cent interest loans, you are quite right. The cost of the loan is far more than you could earn in savings. However, that rule doesn't apply to people on the newer loans, currently only paying 1.5 per cent. If you were to stick the money into a high-interest cash Isa where you could easily get 2.8 percent tax-free, you would be earning more interest than the debt costs. In effect, you would be making money out of not repaying the loan. The only time you shouldn't do this is if you have no self-discipline and might go out on a spending spree and get rid of it.
In that case, the best thing to do is to pay off the debt.