This is a question I am often asked and my usual response is to direct clients to Martin Lewis’s excellent work on this subject at the following link: https://www.moneysavingexpert.com/students/repay-post-2012-student-loan/
However, the following appeared in Times a couple of weeks or so ago and I thought it provided quite a helpful summary of the position.
You asked
“I want to give my daughter £50,000 towards her future. She recently graduated with the same amount of debt on her student loan and is now working. Should I pay off the loan or hand her the money to invest instead?“
Our response
There are now over half a million student loan borrowers in England who owe more than £50,000 each, according to the latest government statistics.
These are largely people who started university after September 2012, when the government allowed university tuition fees to rise to up to £9,000 a year. They are on “plan two” student loans.
But this is an interesting debate because, while they are defined as “loans” on paper, the repayments don’t carry the same rules as typical borrowing.
First, there is no “interest-free” period as such – the interest starts to accrue from the first day of term – but the repayments on plan two loans do not begin until the April after the course finishes, and even then, only once the graduate is earning more than £27,295 a year.
People who took out a plan two loan have to repay 9% of any income they earn above this threshold. The interest is charged at the retail price index (RPI) measure of inflation plus up to 3% (depending on how much the borrowers go on to earn) each year. Earn below £27,295 and they won’t have to pay a penny back.
Thirty years after graduation, the loan is written off by the government.
This arrangement benefits lower earners, but remember that with this type of loan, how much you have to repay is linked to your earnings, not how much you owe. So, if you start your career on a high salary that continues to grow, you are likely to pay tens of thousands of pounds in interest.
So, could you save on this by paying the loan off early?
The maths
Your daughter has £50,000 in debt. You haven’t specified her salary, so let’s take a look at a few different scenarios.
If someone starts their career on £25,000 which rises by 2% a year for 30 years, they will never clear it on their own. By the 30th year, they would have repaid £18,560 and still owe £134,000. In this scenario, it would not make sense for them to pay off the loan upfront.
A graduate starting on £35,000 a year and receiving the same rate of salary increase, would repay £29,388 over 30-years. By the time the debt was wiped, they would still owe £131,579.
A high-flyer who landed a £45,000 starting salary would, in our scenario, pay £67,530 over 30 years. In this case, it could make sense to clear the loan early, as the amount they pay over 30 years would exceed the loan they took out.
Money analyst Laura Suter at investment platform AJ Bell explains: “A starting salary of £40,000, which gradually increases over the next 30 years, is the tipping point where you’ll end up repaying the same amount that you borrowed.”
But even in this scenario, there is a huge gamble involved. If your daughter were to later take a pay cut, reduce her hours or have a career break, you could find yourself in a situation where you paid off a loan that would have been wiped anyway.
How much you repay with £50,000 of student loan debt
[Source: AJ Bell.Based on Plan 2 loan, with initial debt of £50,000, 2% a year salary increases and a starting threshold of £27,295 that increases by 2% each year plus RPI and 9% repayments] These figures are based on plan two loans.
So, should I pay off my daughter’s loan?
Generally, if your daughter is a high earner, who started her career on a salary of £40,000 that you’re confident will continue to rise, they may be better off paying off the loan as soon as they can. By doing so they can avoid some interest payments.
This is because they would always be incurring the highest level of interest – RPI plus 3% – and so their loan would continue to grow with the interest outpacing repayments.
By clearing the loan early, you may also boost her chances of hitting other milestones such as home ownership. Student loans do not affect your ability to borrow money, but lenders do take it into consideration when calculating affordability. As the loan reduces take-home pay, it could potentially affect your daughter’s ability to borrow.
At the other end of the spectrum, if your daughter has an average income, you could consider investing the money instead, as she may never pay off her initial debt and eventually the loan will just be wiped off.
Of course, this is not taking into account potential policy changes. The government has already raised the 30-year rule to 40 for new students from September this year. In the future, more changes could follow, so this is worth bearing in mind.
Suter adds: “It is nigh-on impossible to work out whether you’re better off repaying your loan immediately after university, or holding onto that money and using it for something else.
“It all depends on your starting salary, how much of a pay rise you see over your career, whether you take any career breaks, or whether you work part-time at any point. It also depends on what future governments do with the interest rate you pay on the debt and the threshold for repayments.”
What could I do with the money instead?
One option could be to invest the money. On an average return of 5% a year, that £50,000 would have grown to almost £63,814 after five years. After 10 years it would be worth almost £81,445, thanks to compound interest.
That same money based on a 7% annual return would be worth £70,128 over five years. Over 10, it would be worth £98,358 according to calculations by investment platform Interactive Investor.
Those are significant amounts that could help your daughter to, say, buy a property or prepare for retirement. If you choose this option, speak to a professional financial adviser. While investments tend to be the best way of growing your money, they can go down as well as up.
If property is her primary goal, you could alternatively drip-feed the £50,000 into a lifetime ISA in your daughter’s name. You pay in up to £4,000 a year and benefit from a £1,000 government bonus on top. It would take you just over 12 years to put the whole £50,000 into a lifetime ISA, but at the end of that period, it would be worth a bit more than £83,500, assuming returns of 5% a year.
You may also want to make sure you have a financial safety net in place before investing any money.
Myron Jobson at investment platform Interactive Investor explains: “Regardless of which side of the argument you choose, it is important to ensure that your finances are in good nick before considering putting in more than the minimum toward repaying a student loan.
“This means paying off any outstanding high-interest debts and maintaining a healthy rainy-day fund of three to six months’ worth of salary or more, if you can afford it – and ensuring that other payment obligations are accounted for.”
Summary
As is so often the case with financial planning matters, the answer to what seems like a fairly simple question is….it depends. It will only be from some future vantage point that you will be able to look back and say whether the decision you made was the right one or not. Putting a positive spin on this, as there is no clear-cut answer, you are not likely to have made a terrible mistake, one way or the other.
I hope you have found this interesting but, if you have any questions about this piece or any other finance related matter, please do not hesitate to get in touch.
Yours sincerely,
Graham Ponting CFP Chartered MCSI
Managing Partner
