Excellent !!! You’ve saved some money and are now thinking of overpaying your student loan. But is this the optimum use of your money? Read on to find out why I chose NOT to overpay
“I’m so proud of my son: he’s saved up quite a bit of money since finishing uni and starting work” she said. I asked her what her son planned to do with the money, thinking she’d probably mention saving for a deposit for a house. But, to my surprise she said she’d advised him to pay off his student loan before doing anything else. I thought perhaps I’d misunderstood the nature of the student loan: that it was a commercial student loan and not the government loan. But nope, I hadn’t misunderstood – it was indeed the government loan, the pre-2012 ‘Plan 1’ loan which is much better than the current version in terms of how the interest rate is set (more on this later).
I was less than 5 years into my career as a pharmacist and still had what seemed like a huge loan to payoff, but I’d done the thinking and the maths and it just didn’t make sense to overpay. I tried to explain my logic to my colleague but she just did not understand. She thought I was mad. Fast-forward over a decade later……..my friend and I were reflecting on this decision while on a sunny beach in Ibiza. We talked about how this decision had helped us to free up cash for investing but more importantly, how the cumulative impact of these types of thought processes over the years has been to dramatically improve our financial position relative to where we started.
This article focuses on my rationale for not overpaying my student loan, but the points discussed can be applied to other financial dilemmas.
Remind me again – What type of loan are we talking about?
I’m glad you asked. I must stress that this article ONLY covers the UK government student loans, administered by the Student Loans Company. There are all manner of what I call ‘commercial student loans’, which have different rules and the decision to overpay these loans or not will very much depend on detailed consideration of the interest rates, fees, e.tc and how it relates to your personal situation and goals.
A Brief History of UK Student Loans
Can you imagine the skills shortage post World War 2? The nation needed to be rebuilt and free education was certainly paramount, along with other elements of the welfare state such as the NHS. The Education Act of 1962 made it a LEGAL obligation for all full-time university students to be offered a maintenance grant for living expenses. This morphed into means tested maintenance grants by the 1980s. Notice that TUITION FEES WERE FREE. What a great time for baby boomers and early generation Xers.
1990 to 1997
In 1990 the government introduced student loans to provide students with additional help, over and above the maintenance grant, towards living costs. The interest rate is set each year (in September) based on the rate of rate of Retail Prices Index (RPI) inflation from the previous March.
1998 to 2011
Fast forward to 1998 when means-tested tuition fees of £1,000 per academic year were introduced, gradually increasing to £3,375 by 2011. Maintenance grants were also replaced with student loans for all but the students of low income families. There were some differences in Scotland and Wales, which I won’t cover here. The official name for this scheme is ‘Income-Contingent Repayment (ICR) Plan 1 Loans’. Key features of this scheme are:
Interest rate is the LOWER of either the Bank of England (BoE) base rate + 1% OR the rate of inflation based on the RPI from the previous March
At the time of writing, the current interest rate is 1.25% (BoE base rate of 0.25% + 1% = 1.25%) Since 1.25% is lower than the RPI from March 2021 (which was 1.5%), the applicable INTEREST RATE IS 1.25%
Repayment is 9% of earnings over £19,895 a year.
2012 to Present
The post-2012 scheme is unneccassarily complicated in my view and has become a politically charged matter. Tuition fees are the highest they’ve ever been – they go up to roughly £9,000 a year. A typical student starting university in their teens, would be eligible for a student loan covering both tuition fees and maintenance loans. The scheme is called ‘ICR Plan 2 Loans’ Means tested maintenance grants are also available for the poorest students. ICR Plan 2 loans have the following key features:
An interest rate of RPI + 3% is applied to the loan while you are still studying (Go figure why anyone thought it would be a good idea to levy the extra 3% on students)
In the April after you graduate, the interest rate varies depending on how much you earn. Broadly, your interest rate is RPI if you earn less that £27k..ish per year. It rises gradually from RPI to RPI + 3% from about £27k..ish to £49k…ish. Once you start earning over £49k..ish (i.e once you move into the 40% tax bracket) the interest rate is RPI + 3%
Similar to the ICR Plan 1 loan scheme, repayment is 9% of earnings over £19,895 a year
There are potential changes on the horizon. Following the Augar Review of student finance (google it to learn more), I am hoping that positive changes will be implemented such as cutting fees, reintroducing grants, cutting the interesting rate on loans while studying and extending the duration of loans. But we shall see what happens in 2022.
I am now going to cover 4 key reasons why I chose not to overpay my student loan even when I could
1. It Makes No Sense to Overpay If Planning to Buy A Property
Buying a home will most likely be on the minds of many young graduates. There are a range of government schemes for first time buyers including the Lifetime ISA (LISA), Mortgage Guarantee Scheme, Help to Buy: Equity Loan, Shared Ownership and Right to Buy. Please click on this government link to check which scheme is right for you The common factor among all these schemes is that you need to have saved some cash to benefit from the scheme.
Say you then saved £5,000 two years after graduating. A large amount, but not quite enough for a deposit for a home. You might be looking at your student loan statement, thinking…..’my goodness that’s a lot of interest just mounting on my student debt’ particularly if you are on the post-2012 scheme. It seems logical to overpay the student loan to reduce the debt right? NO NO NO in my opinion. I could make the NO NO NO nicer by getting Destiny’s Child (90s rnb supergroup) to sing it.
First of all, it’s important to REFRAME your thinking around student loans: try to think of it as a GRADUATE TAX instead. When was the last time you paid much attention to deductions for National Insurance Tax on your payslip? Recall that you’re paying in effect a 9% tax above the threshold: for example if you earn £32,295 a year, which is £5k more than the current £27,295 threshold for the post-2012 scheme, you’re paying £450 a year (£37.50 a month). This payment of £450 a year will not reduce even if you were to overpay the student loan by the £5,000 you’ve saved. All that would happen is that the time horizon over which you’ll keep paying the 9% tax will probably reduce. But this is not a smart thing to aim for given that the loan is wiped after 30 years (post-2012 scheme) regardless and it is estimated that over 80% of English students will have their student loans squashed by the time they retire, as they won’t have cleared the loan + interest within 30 years.
What if you decided to put £4,000 of that £5,000 saved into a stocks and shares LISA instead? You would immediately benefit from a 25% government bonus, which means your £4k has magically become £5k. This alone wins the argument as 25% is much larger than the highest interest rate charged to the post-2012 scheme: RPI + 3%. The RPI was 1.5% in March 2021, therefore the highest interest rate based on March 2021 RPI is 1.5%+3% = 4.5%. WHAT IS 25% MINUS 4.5%?
Wait.. there’s more potential good news. As it’s a stocks and shares ISA, you could potentially benefit from growth in the stock market, particularly if you are investing over a 5-10 year time horizon in a well diversified basket of stocks. Even if not prepared to invest in a stocks and shares LISA, you can still invest in a simple cash LISA, which will also get you the 25% government bonus.
Another thing to consider is HOUSE PRICE INFLATION. UK house prices increased by 11.8% between September 2020 and September 2021, This level of increase in a year is atypical, but property prices, which go through phases, up and down like a yoyo, have been on a general upward trajectory over the long term. Have a look at the average UK house price growth between 2006 and 2021 below.
I hope it’s immediately obvious that every year one delays in buying their home potentially costs them between 5% and 7.5% per year after deducting RPI. Which of these two scenarios makes sense to you?
Ngozi, a Computer Science graduate, is year 5 into her career as a Database Analyst (DBA). She has amassed £32k of savings having invested £4k a year in a stocks and shares LISA for the last 5 years. She purchases a 2 bed flat in Liverpool for £125,000. She notes that the mortgage lenders did not give two hoots that she still has outstanding student loans.
Chioma studied at the same university as Ngozi and is also a DBA. She saved the same amount as Ngozi (i.e. £4k) every year but felt soo psychologically burdened by what she thought was student debt that she overpaid £4k a year. She’s pleased to see the size of the student loan reducing each year, but is a little irritated when she learns that she is still paying 9% of earnings over £27,295 and is therefore no better off than her friend Ngozi in terms of yearly cashflow. She wants to buy a flat just like her friend Ngozi, but has no money saved. Ngozi invites Chioma to be a lodger in her flat and charges Chioma mate’s rates (i.e. lower than market rent). Ngozi doesn’t mind as she feels she’s helping a friend out and besides she’s using the government’s rent a room scheme, which means she can earn up to £7,500 a year tax free. Fast forward another 5 years and Chioma’s career has really taken off so she can now purchase a 2-bed flat in Liverpool next to her friend, except the price is now £175,000. She’s wondering if she made the right decision overpaying in the first 5 years of her career.
In my case, I already had a residential property and a buy-to let property within 1 year of graduating as I’d started investing in property early while still studying for my first masters degree in Pharmacy. Note that it was the student loan that got me on the property ladder. I basically saved all of my student loan over the first three years of my degree and used that as a deposit for my first home – a ‘crappy’ one bed flat in a block of flats in a not so great part of town that you wouldn’t have been proud to announce that you’d bought. Truthfully, I seriously considered just paying back the student loan as the concept of being in any sort of debt worried me a lot, given that just over four years prior to that, I’d been in a homeless persons unit.
I remember discussing my case with a couple of EXPERIENCED friends/family members within my circle BEFORE making the decision to commit my student loan savings to purchasing my 1st property rather than simply returning it to the Student Loans Company. These discussions took place MULTIPLE TIMES as I was quite risk averse and so needed ENCOURAGEMENT and RE-INFORCEMENT of the main messages, but ultimately I felt that the CHOICE was MINE to make after WEIGHING up the OPTIONS.
Having had success with these early property moves, it was clear to me that, as my pharmacy career began to take-off, I needed to keep saving and building pots of money for further property investment rather than overpaying my student loan.
2. Overpaying is not the best Return On Investment (ROI)
In simple terms, Return On Investment is a way of assessing the pay back of an investment decision relative to the amount invested. The calculation is net profit divided by the cost of investment. Easy enough to understand, but there’s more to it than meets the eye and I strongly encourage you to read this article I wrote on the subject with detailed examples related to personal finance.
Notwitstanding the comment I made earlier about the fallacy in trying to reduce the student loan debt, given that you’ll still be committed to paying 9% above an income threshold and the fact that most students in the post-2012 scheme would likely have their loans wiped before they are able to pay if off, it is still a worthwhile exercise to do ROI comparisons. So, let’s use the worst rate possible, which is the post-2012 scheme’s RPI+3%. Earlier I worked out a figure of 4.5% based on the RPI from March 2021. Let’s assume that this is the ROI of overpaying the student loan, even though in reality it’s much less since your year to year cashflow doesn’t change when you overpay. Say you saved £4,000. Rather than overpay and ‘EARN’ 4.5%, you could:
Invest in a Cash LISA and benefit from a 25% government uplift (GUARANTEED)
Invest in a Stocks and Shares LISA and benefit from a 25% government uplift (GUARANTEED) plus benefit from an extra 5% per year uplift in the stock market (Not Guaranteed).
Start a Side-hustle business generating a ROI greater than 4.5% a year
Invest in a standard Stocks and Shares ISA
Invest in Cryptocurrency (nb – HIGHLY RISKY, but some have made it work) generating 25% - 100% return per pear (Not Guaranteed)
Invest in a professional qualification that could boost your earnings potential
Of course none of these are personal recommendations to invest. I’m simply highlighting other potential options for your cash. I deployed all my savings into property investment as that was what interested me. If you are terrified of investing for FEAR of loosing your money, this is not necessarily a bad thing, WHILE YOU ARE YOUNG. I was similarly very very afraid when I started out and it made me cautious. This caution helped me to avoid the sharks. However, it’s important that you start with small amounts while you are still young and ideally BEFORE you start a family. It’s like building muscle in the gym: you have to start with lighter weights and then gradually build up. Don’t be afraid of failing as you have loads of time to recover when you are young. Please remember that you are a university graduate and no matter what course you studied, you have demonstrated your capacity to LEARN. Channel some of your brilliance towards learning about investing by reading books, watching you-tube videos, listening to podcasts e.tc. Then TRY IT OUT.
3. You Have a Greater Capacity to Save Early in Your Career
It may seem counterintuitive to suggest that for many young graduates who start work, their highest savings rate would probably be in their first 5-10 years of work, despite the fact that it also corresponds to their lowest income earning period over the life-time of their career. It comes down to having less responsibilities (e.g no kids) and greater flexibility in lifestyle choices. My early-mid 20s self could choose where to live to save on housing costs. Yes, I owned my own property, but if I didn’t I would have been prepared to live in a much cheaper part of town and have a longer commute to work. Some friends were able to save practically all their income by living with their parents. My expenditure on grocery was relatively low, I went for an average car. Thus my savings rate was very high even though my income was low compared to what it is now. It can be harder to save in your 30s, particularly if you have kids as this will limit your flexibility. You may now prefer to stay in an area with good schools, no matter how expensive, you’ve got extra mouths to feed, extra activities to pay for, holidays are a lot more expensive, you may need a bigger car e.tc. Even if you don’t have kids, you’ve probably acquired more expensive tastes. As you get older, you may have to look after your elderly parents as well as kids.
What does this have to do with the decision to overpay the student loan or not? Well, the point is that if you overpay early in your career, you’ll be overpaying at a time when you have the greatest capacity to SAVE and therefore the greatest capacity to INVEST. The magic ingredient in many investments is COMPOUNDING, which is a function of TIME. Smaller amounts invested in your early 20s can build up to life changing amounts in your 30s and 40s. Below is a fictitious story to illustrate.
King Adewale was a very rich Ooni of Ojuelegba. He loved games and often played a game called Ayo Olopon, which involved strategically placing 48 Ayo seeds in a carved wooden box containing 12 holes. One day, a Yoruba (an ethnic group prevalent in Nigeria, Benin and Togo) merchant called Yemi, presented an interesting game called Chess to the King. King Adewale enjoyed it soo much that he offered Yemi any reward that he wanted. Yemi asked that a single grain of rice be placed on the 1st square of the chessboard, then two grains on the 2nd square, four grains on the 3rd and so on – doubling each time. King Adewale looked at Yemi in disbelief and said to himself ‘which kind mumu be this’ (i.e. this man is a fool - in regular English). King Adewale laughed hard and instructed his treasurer to pay the reward as agreed. A week later, Yemi visited the king and asked why he had only received part of his reward. The King, full of rage, summoned his treasurer and demanded to know why such a simple reward had not been honoured. The treasurer explained that the entire kingdom did not have enough resources to pay the full reward and so only a part payment was issued. The King soon realised that the exponential growth of the rice payment meant that on the 20th Square Yemi’s reward would have been 1 million grains of rice , on the 40th square, 1 billion grains of rice and finally on the 64th square more than 18,000,000,000,000,000,000 grains of rice which is equal to about 210 billion tonnes. King Adewale was really impressed with Yemi’s cunningness and invited him to be his olori onimoran (i.e. chief advisor).
Whilst you may not get a doubling (100% ROI) of your money (like Yemi’s rice) every year, the MAGIC of COMPOUNDING can still yield amazing results over the long term, with modest ROIs of 4% to 5% per year, which is achievable in the stock market and other asset classes. So why in the world would you overpay your student loan?
4. You May Achieve Financial Independence Before the 30 Years Are UP
I must admit that this reasoning is very unconventional. Financial Independence (FI) is all about being able to have a set lifestyle as defined by YOU, without needing to earn an income from a day job. This is because you have amassed enough assets generating passive income to support your lifestyle. Click here to read an article I wrote questioning if FI is realistic. Now, imagine if you were to save aggressively early in your career and managed to build a huge portfolio of shares paying dividends by your late 30s having invested wisely (Please read the book Millionaire Teacher by Andrew Hallam for inspiration). Say you were also mortgage free (google ‘FIRE community mortgage free’ to see how), your household expenditure could be so low that you can comfortably live off less than the £27,295 threshold (£54,590 if a couple). After all, mortgage payments/rent payments are the biggest drain on income. So even though you still have outstanding student loan debts, you wouldn’t have to pay a penny as you're living under the threshold. How about if you haven’t achieved Financial Independence, but your job allows you to have a location independent lifestyle – like living on a beach in the Phillipines, while earning in £. What’s £27,000 in Phillipine pesos?
Money Thoughts (this blog) is all about contextualising information into ideas that can lead to action. Please don’t simply nod your head in agreement after reading this article. Now that I have convinced you not to overpay your student loan, try to take action with the money you’ve saved.