Why is it not logical to pay off just the interest on your student loan?

Aussie_Tips

Bear with me for a minute

I get the logic about not particularly worrying about the loan amount or interest, and that for older plans the loans may be written off, but for new students doesn't it make sense to pay off the interest each year (obviously if it's affordable)

I haven't fully done the maths (ok I haven't actually started it), but if you expect at some point to earn enough to have loan repayments taken from income, surely it makes sense to try and pay the annual interest so that when you reach the point that you're actually going to have deductions taken from salary they are mostly paying of the loan amount and not the interest 🤔

Or have I completely left the reservation?

itsthelittlethings

If you're never going to pay the loan off (and most people won't) it really doesn't matter how much interest is added.

Aussie_Tips

https://forums.moneysavingexpert.com/discussion/comment/81872077#Comment_81872077

With the new plans, my understanding is that most will reach the threshold for starting to pay it off and the level of payment (9% on income over the threshold) could be a chunk. As such I would have thought that it would be beneficial to ensure that when you come to pay that repayments are focused on clearing capital and not forever paying off interest 🤔

itsthelittlethings

https://forums.moneysavingexpert.com/discussion/comment/81872098#Comment_81872098

Why, if you're never going to pay the principle off? You don't pay more the more you owe. The interest could mount up to £1000 or £1,000,000 it really doesn't matter.

itsthelittlethings

I think you're fundamentally misunderstanding something here.

Aussie_Tips

https://forums.moneysavingexpert.com/discussion/comment/81872102#Comment_81872102

Yes it will be written off after saying 40 years, however I'm wondering if early interest payments plus reduced repayments over the term (which could actually result in paying the loan off and therefore more cash in your pocket) will be more beneficial than full term duration repayments 🤔

I think I need to do the maths 😁

Kim_13

Paying off the interest as it is added is a voluntary overpayment at the end of the day. If the balance of the loan is such that they never clear the amount borrowed, then paying the interest was a waste since it would have been written off in its entirety.

Avoiding the interest compounding as you suggest will benefit those graduates who repay in full - but we don't have a crystal ball to know that will apply. One can make a better judgement once in work and knowing how secure it is etc, but by then a significant amount of interest will have been added. Given that maintenance loans are not keeping pace with living costs, I suggest very few have a choice but to accept the compounding (at higher rates) while studying.

silvercar

Under Plan 5 loans, more people are expected to clear the loan in full, or at least pay more than the principal amount, so it makes sense to clear the loan early if you can afford to. Previously on Plan 2 it was far fewer people expected to clear the loan, so it made less sense to clear it early.

I think more people will be estimating if they fall in the group of people who would be better off clearing it early.

Whereas the numbers may make sense to clear the loan, remember to consider what else you can use the money for that would benefit you more. Thinking particularly of home deposits and pensions. If an extra £20k means a lower interest rate on your mortgage, due to lower loan-to-value ratio or even it makes the difference between being able to afford to buy or to stay renting, then I’d consider carefully whether paying down the student loan is sensible, even if the numbers make sense in isolation.

Aussie_Tips

https://forums.moneysavingexpert.com/discussion/comment/81872167#Comment_81872167

That's my thinking too. However it's a bit of a catch 22. You don't know if you fall into the pay it off category at the time you need to decide to pay off the interest. I'd like to see some models of average loans and average wages over the loan term to give some guidance so that people can make an informed decision (obviously based upon known knowns).

I wonder if MSE has any spreadsheet wizards that could help.

silvercar

https://forums.moneysavingexpert.com/discussion/comment/81872286#Comment_81872286

You can always wait, you may lose some interest while you wait, but the decision can be made at any time. I think reducing the risks would be to wait until you are in your first proper graduate job, then you can look at websites like glassdoors, or an AI, to estimate future salaries and go from there.

2hc9kmju

Hi Aussie_Tips,

So presume your from Australia? Which part? I'm from Sydney…

I'm also a Chartered Accountant and following the recent press coverage have done some calculations about income levels and how much you'd need to repay debt in full. I've based it broadly on Plan 2 base data and they are indicative only and not actual examples of how they'd affect a specific individual.

I also have a graduate on Plan 2 and an under-graduate on Plan 5, so this is clearly of interest to me.

In summary need an income of £50k p.a. to pay the principle sum on the debt over 30 years - effective interest rate would therefore be ZERO.

At about £77k p.a. you'd repay the full debt (debt and interest) over 30 years.

They both assume the salary remains flat over the term of the debt and RPI is about 3% p.a. for the full term - trying to calculate a realistic salary growth and RPI for the future is fraught with problems and so any potential forecast is likely to be unreliable

However, given the uncertainty of future debt repayments a better solution may be to actually invest the money in an ISA and review your debt position annually to ascertain whether repayment is financially beneficial. if so then you've saved a lump sum that can be used to pay it off and if not, then you have a lump sum for other purposes, and the debt then gets written off.

As none of us knows what the future holds and a wide range of life events may mean that more of the debt is written off than we currently expect NOT putting the money into the debt, but investing it would result in a win/win situation for the graduate - they have a lump sum to pay off the debt if their income grows high enough to warrant it, but they have a lump sum for other purposes if it doesn't.

Reviewing the position annually would help in understanding where the graduates financial position is vis-a-vis repayment or write-off of the debt and they could then flex the investment accordingly.

Interestingly, my modelling shows that an investment of no more than 5% of income over 30 years would only require a compound growth rate of 0.5% (yes less than 1%) to have enough to repay the debt in full after 25 years. Investing in high yielding shares (5%) on LSE and using household names and routinely reviewing the investment portfolio would accomplish this easily. Alternatively a managed ISA might be a reasonable alternative too.

However, the modelling has a lot of variables, with pretty much all of them being unique to the graduate concerned, so each graduate really needs to forecast their own position to make an informed choice - not an easy task for non-finance graduates, though the maths itself isn't that complex.

Lastly, if you plan to use one of the online tools to do these calculations, many of them make assumptions about the variables that may or may not be what you expect and a small difference in salary growth or RPI, has a massive effect compounding over 30 years of so.

I have mentioned on other threads that VERY CAREFUL use of AI models may be helpful to understand your individual circumstances, but you need to check all parameters that the AI model uses to do the calculations and better still provide it with exactly what it needs (so it is just doing the maths) and conduct some sensitivity analysis on the key variables (RPI and Salary growth).

Hope this helps in understanding the vagaries of Student Debt repayment and why repaying it with a lump sum early is still often the wrong thing to do for many.