Should you pay off your child’s student loan?

It may be a while since university, so it can be useful to see how much money originally taken out as a loan. Or to see the interest that has been accrued. This infomration can be useful in deciding to pay off the student loan or not.

Go to https://www.gov.uk/sign-in-to-manage-your-student-loan-balance 

Log in with the CRN and password and the current student loan balance should be visible.

This is the current amount owed plus your current interest rate. To see more information, go to “view your correspondence” which is a tab on the right-hand side of the webpage as below.

Screen shot from the student finance Website showing how to get to the view your correspondence tab. (Manage your student loan balance, gov.uk, accessed 21/04/2022)

A more detailed breakdown of interest is available by going to the annual statement. There should be one annual statement issued in September the year after graduation which will include a breakdown of the loan interest from the start of your course to the end of your course including monies received.

Please note that the interest while studying is RPI + 3%.

The image shows from within the view your correspondence tab and for key information on the Student finance loan go to the Annual PAYE Statement. (Manage your student loan balance, gov.uk, accessed 07/11/2022)

This statement will breakdown all payments made and is a useful point to see how the debt grows and in real terms the interest that is being added.

Student loan interest rates are based on the RPI (Retail Price Index) (Glossary Retail Prices Index (RPI), Thomson Reuters, accessed 07/11/2023) plus an additional rate which applies whilst studying and if earning above certain thresholds as mentioned later.

RPI is an index which essentially takes a basic of goods across the UK and then determines over time whether the price of the basket of goods is increasing or decreasing.

If the basket of goods is increasing, then this is one way to measure inflation.

Higher inflation simple means that the price of the basket of goods has increased more thereby reducing your ability to buy the same amount of goods as in previous years.

While studying and until the April following graduation, RPI + 3% is applied. Afterwards, the rate of interest is then linked to your earnings as per the below figures.

If you earn:

• Under £27,295/ Interest rate = RPI
• Over £49,130/year. Interest rate = RPI + 3%
• From £27,296 to £49,130. It rises gradually from RPI to RPI + 3%. For example, earn midway, so £38,213, and your rate will be RPI + 1.5%

Please note as this is based on earned income this will also include dividend payments.

For student loans, the RPI rate is set on the 1st of September and is based on the previous March figure. The RPI rate for 2021 March RPI was 1.5% meaning 4.5% RPI (1.5% for March, plus 3% for higher earners) interest rate for those earning over £49,130.

However, this also means an interest rate of 1.5% for those earning less than £27,295.

High levels of inflation puts more pressure to pay off inflation-linked loans as the debt will grow faster. However, it is important to consider, Student loans are repaid over an extended period which means that the inflation rate does average out. For some more information you can look at the Annual inflation rate of the Retail Price Index in the United Kingdom from 2001 to 2027, (Statista, release date October 2023, accessed 07/11/2022) using data from the Office of National Statistics to produce a useful chart to see how RPI has varied since 2001.

As student loans are typically paid over decades this gives opportunities for inflation to average out over the long term. Although there might be periods of high inflation there are also periods of low inflation like we have seen up until 2023.

A critical point worth mentioning is that the loan currently wipes after 30 years, meaning that in theory, you could never make any repayments to the student loan and then have it cleared. It is also worth noting that the debt is cancelled on death and so won’t pass onto anyone else.

The student loan repayment structure is more similar to an increase in marginal tax until the student loan is repaid or cleared.

Effective marginal tax rates exclude NI 2021/22

This table highlights the effective marginal increase on tax rates created by the student loan repayments.

One issue raised was paying off the student loan or putting money towards a house deposit. First, the student loan is not considered in a housing application as a lump sum debt however it does have an impact on the amount that can be borrowed as it forms an additional outgoing expense.

The loan is repaid more like an additional tax on earnings, so unless you repay the whole loan amount then there will be no impact on monthly outgoings. Therefore, reducing the student finance loan by £10,000 will have no real impact on housing affordability, until the whole loan is repaid.

So, the natural next question is should I pay off the student loan at all, and ultimately, it comes down to whether you can achieve a better return elsewhere.

From a strictly economical point, it is preferable to only repay the student finance loan if the interest is greater than what can be achieved elsewhere. If you assume that the stock market can return 7% after fees and currently student loan for higher earners is at 4.5% then it makes sense to focus on the 7% return.

Why?

Earnings from the investments will outpace the debt, assuming that the average return is greater than the interest on the loan.

Look at the below graph.

This graph was created from a model which shows the option of a higher earn paying the minimum amounts required on the student loan and investing a £10,000 lump sum and an additional £3000 per year. The Graph Highlights that with regular savings the debt could be repaid in approximately nine years. If this money were to be used to pay off the debt quicker, it would be achieved also in 9 years. However, the key advantage is that the money invested is more flexible and can be used for other uses or left to continue generating additional growth which will likely be outpacing the debt at this point.

This graph was taken from a simplistic model that looked at investing an initial lump sum of £10,000 with an additional yearly lump sum of £2,400 versus paying the minimum repayment amount required from a higher earner (£49,130). Investing this amount would allow someone to pay off the debt in approximately 10 years. However, it does not factor in market downturns and assumes a 7% average return after fees which is in no way guaranteed. What you would actually get back would depend on the actual return and tax treatment of the investment.

What the above graph is highlighting is that the returns generated from the stock market with steady investing provides the potential to outpace the student loan debt.

When comparing the options of paying down the student loan faster or investing, investing over the long term provides the potential to generate greater gains even if you are a higher earner. Again, if the after-tax return of investing is greater than the interest rate on the student loan then investing is preferred.

For 2021, a higher earner will pay a student loan interest rate of 4.5%. However, the average interest rate for higher taxpayers from 2012 to 2021 is approximately 5.59%. As seen in the below snapshot. Please note, that additional information on RPI statistics is available from the Office of National Statistics (RPI: Percentage change over 12 months – All Services, published 18 October 2023, accessed 07/11/2023).

This table highlights the RPI rates from 2012 to 2021. It shows what a lower earner and a higher earner's interest rates are for the student loan. (RPI: Percentage change over 12 months - All Services, published 18 October 2023, Accessed 07/11/2022)

So, from this perspective, there is a slight preference for investing. For those who are lower earners, the interest rate is reduced and so the preference for investing becomes stronger.

Again, this is all assuming that a 7% return after fees is achievable. Likewise investing is riskier, so you need to be able to accept the market fluctuations and that it may take longer than was envisaged to see the expected returns.

Other schemes might make investing more attractive. One scheme is the UK Government LISA (Lifetime-isa, gov.uk, accessed 07/11/2023) which pays an additional 25% up to a maximum contribution amount of £4,000 per year than the whole £5,000 can be invested into the markets. In this instance, it is far more valuable to choose the LISA over the long term.

We cannot guarantee that the average interest rates and the stock market returns won’t fluctuate, they will, but given the initial government boost, this makes this option more attractive for long-term retirement saving.

But this is only one option and in actual fact depending on your circumstances other options may be far more attractive. 

It is worth mentioning the limitation of this study, the study has assumed a consistent return over time and a compounding 7% per annum. Realistically, the markets will fluctuate more violently however as investing is a long-term endeavour the longer the time spent in the market the more likely it is that any fluctuation will even out.

You might also find that the 7% figure used in this model is not applicable but is simply used to demonstrate the fact that you should consider other alternatives to paying off the debt.

This means that although the portfolio may underperform at times there is also the opportunity for the portfolio to outperform. As the focus of this work was on parents gifting to their children it is often the younger ones who have time on their side. As a result, younger generations can afford to take greater risks and potentially reap greater financial rewards.

Although this may not be an appropriate course of action for everyone it does enable a younger person to invest more aggressively and have the potential to pay off the student loan sooner. Although this should also be balanced with the fact that there is the potential to lose money as well.

Everyone feels something, fear worry, excitement.

These emotions all form part of the human psyche and it’s often an underlooked aspect of whether to look at paying off the student loan or at alternatives.

Debt is certainly seen as a negative and there is a natural predisposition to want to repay the debt even if it is more favourable to focus on other avenues.

It may bring relief for someone to not have student finance debt to worry about. And the key here is to look at your child’s attitude to risk. If they are very risk-averse or don’t deal well with any stress, then it might make more sense to pay off the student loan rather than let it grow and produce extra anxiety.

A crucial point worth considering is that the student loan debts will not exceed average commercial rates. The government call this the interest rate cap.  (How interest is calculated – Plan 2, gov.uk, accessed 07/11/2023) In other words, the student loan during periods of high inflation should be capped. As there is a cap this should put further emphasis on looking to assets that can beat inflation over the long term.

Another factor worth considering is the inheritance tax position of giving your child a large lump sum. Each year you are allowed to gift £3,000 to someone (How Inheritance Tax works: thresholds, rules and allowances, gov.uk, accessed 07/11/2023) without any inheritance tax implications.

You can also backdate this £3,000 one year meaning that if you have not gifted before, you can gift £6,000 per parent for first-time gifting. For a two-parent family, you can give £12,000 away with no inheritance tax implications.

Importantly, this £12,000 is not per child but is a maximum figure. If you gift more than the benefit amount you are entitled to, then the 7-year rule  (How Inheritance Tax works: thresholds, rules and allowances, gov.uk, accessed 07/11/2023) will apply.

Inheritance tax planning can be a complicated subject, but it is worth considering as part of an overall plan between you and your children. After all, you don’t want to leave them with an increased tax bill should something happen to you.

While investing may be riskier than paying off the debt it does allow for increased flexibility which paying off the debt does not allow. For example, if you pay £10,000 off the student loan then monthly payments remain the same and you cannot have access to that £10,000. The saving is that less interest is generated in total.

If you invest the £10,000 instead the money can be used to pay off the student loan, or it can be taken out as a down payment on a mortgage or you could continue to save and earn interest. The point being is that once the money is used to pay down the debt it cannot be used for other purposes.

The answer to whether to pay off your child’s student loans is not an easy one and it is often best done through a family discussion and finding out what your son or daughter’s priorities are and then you can see about better aligning your thoughts.

If you are on Plan 1 it is likely that you should leave paying this off for as long as possible unless there is no other use for your capital. This is a cheap loan and in real terms the debt does not increase, making other options even more attractive than might be the case under Loan Plan 2.

Plan 1 student finance loans were those issued generally before 1 September 2012 and have recently undergone a rate change in January 2022. (Change to Plan 1 student loan interest rate, gov.uk, published 13/01/2022)

The Plan 1 threshold is currently £382 per week or £1657 per month which is approximately £19,884 per year. Anything over the threshold is charged at an additional levy on income of 9%.

The key with Plan 1 is that whilst the threshold is lower the amount of debt accrued is also generally lower and so is the interest rate on the debt. Whereas with Plan 2 the interest rate could have an additional 3% on RPI Plan 1 follows RPI meaning that in real terms the amount of debt never increases. The Logic of arguments is the same as for Plan 2 only the debt is smaller and the interest is even less putting a heavier weighting towards alternative uses of your money.

The Government’s position on future student loans (Sweeping changes to student loans to hit tomorrow’s lower-earning graduates, Institute for Fiscal Studies, published 24/02/22) is a focus on repayment and is currently tying the loans directly to RPI.

The student loan repayment period is likely to shift to 40 years from 30 years.

The repayments terms are likely to be linked to RPI, reducing any real terms’ negative impact on finance.

A lower repayment threshold of £25,000.

It is important to note that high-income earners will save additional funds compared to the current Plan 2 scheme. The new scheme is unfortunately likely to hit hardest on the lower-income earners after university as there is a longer loan period.

However, as the new student loan does not increase in real terms there is a stronger argument for the new cohort to avoid paying it back and focus on saving for the first home and for the future where in real terms the growth of their money will be greater. Of course, there is scope for the government to make changes in the meantime. However, the initial thoughts are that it puts less emphasis on the desire to add additional repayment of student loans.