You Don’t Understand How Student Loans Work
Today we have an interesting post for you. It is a guest post by Haydn who writes for his blog Perpetual Prudence. He focuses on investing, especially the concept of lifetime Investing, as well as talking about personal finance, investing psychology, investment risk, and more! If you have a question for him about this article or anything else you can reach out to him on Twitter. Please do check out his blog.
Jessica was born in 1992 in an undisclosed location in the home counties. She was brought home to a 6-bedroom house, complete with a swimming pool and a tennis court. Growing up she enjoyed riding, playing hockey, and spending summers alternating between their second home in Devon and a variety of global locations. She attended private school exclusively (except for nursery, where she, unfortunately, had to mix with normal people) before heading off to a top UK university, where she scraped a first. Taking a job in operations at a bulge-bracket bank in London, she promptly moved into the Clapham-area with some of her friends from school after uni (she was not short of options when it came to housemates).
Jessica was excited to receive her first paycheck from the bank (and to spend some of it at a bar in the city that evening). However, when the money entered her account, she was dismayed to see a sizable percentage of her income had appeared to have been confiscated by the “Student Loans Company”. How unfair.
Later that evening at said city bar she registers her complaints with an ok-looking (although his nose is too large and crooked) bald guy who appears to be roughly 29 years old (but is actually 25):
“How can they take that much away from my income, it’s so unfair! No one told us about this when we were going to university…it’s a scam! And I heard the interest rate they apply to the loans is like 10 percent…I’m never going to pay mine off!”
“It seems to me that you don’t actually understand how student loans worked. Have you ever actually researched them to see what you have to pay and when?”
“Well…no, but it’s ridiculous how much we pay right?!”
I walked away to search for a more interesting conversational partner (although I must say I struggled at a bar in the city).
Know the rules
Don’t be like Jessica. There is very clear information out there regarding student loans. The core of which is outlined below…
Pay your taxes
Student loans aren’t really like loans at all. Yes, you have to pay back money that interest is applied to but there aren’t the same laws regarding this debt that are applied to normal debt. Your payments are taken as a percentage of your income. The higher you earn, the more (in absolute terms) you pay. If you stop earning significant amounts of money, the Student Loans Company will not send debt collectors to your house to confiscate your TV. In fact, if you still haven’t paid off your loan after 30 years of leaving university, it is written off entirely (this happens a lot).
A better way to think of it is to think of it as a tax for using a public service; the same way you should pay taxes for using the NHS. It is simply a tax for participating in the incredible privilege that is attending a UK university.
What’s the plan?
How much you end up paying is dependent on which plan you are part of. There are 3 basic plans: Plan 1, Plan 2, and Postgraduate:
You can find all of this information, and more, here.
As you can see, you will pay different amounts, and experience different interest rates, depending on what plan you are subjected to.
Jessica is an English student, as in English nationality, who started university (Durham) in September 2014. This makes her part of Plan 2. She is earning somewhere in the range (she wouldn’t tell me her exact income) £25,725 – £46,305, so the interest rate applied to her debt will be RPI +0-3%. She will experience hefty deductions from her income, as well as high-interest rates applied to her debt.
However, someone on Plan 1 with a lower income (and doing a non-boring job) will pay a much lower percentage of their income and have less interest applied to their debt. Lovely.
Plan 1 asks you to pay earlier but applies a lower interest rate to your debt.
What is an RPI?
You may have noticed that the interest rate applied to your debt (at what rate your debt grows) depends on some things called the RPI and the Bank of England base rate. If you are fortunate enough not to have studied Economics at some point in your life you probably have not come across these terms before.
PRI (Retail Price Index)
This is a measure of the level of prices of a bunch of goods and services in the UK. You can monitor the change in the level of this index to get an estimate of consumer inflation.
For example, you look at a basket of eggs, onions, and garlic – assuming you like omelets – and note their total price today as £10 (you must shop at Waitrose). This is indexed to 100. So, even though the total price of your bundle is £10, the index level of your bundle is 100. This number is arbitrary: we simply label this price level as in the index level 100. Now you buy the exact same items tomorrow but the price is now £11. This pushes our index level up to 110: (11/10)*100 = 110. So the inflation in the price of our bundle is 10%: (110-100/100).
The RPI works in the exact same way, except at a much larger scale.
Bank of England Base Rate
This is simply a rate that the Bank of England sets. Their ‘official’ mandate is to set this rate, and engage in other activities, to maintain inflation at 2% (because a certain amount of inflation is seen to be ‘healthy’ and ‘good for the Economy’ for some reason). The basic principle being that higher interest rates will discourage inflation and lower interest rates will encourage inflation. It is via this mandate that the base rate is related to the RPI.
What’s going to happen in the future?
I don’t know (and no one does). Anyone that claims to know should not be listened to.
Many, many things could change:
- Fees could change. I remember when fees for universities tripled from £3,000 a year to £9,000 a year. Or someone crazy might campaign offering to wipe out student debt (who Jessica may vote for before returning to more right-wing voting activities in her 30s).
- The amount you have to pay could change. Tomorrow the government could enforce you start paying 15% of your income towards your debt repayment. Jessica would really not like this one.
- The interest rate applied to debt could change. The next governor of the Bank of England could go bold and set interest rates at 20%. We could see very severe inflation (usually a bad thing). The way that interest rates are applied to your debt could change altogether.
- You might change. You may move abroad. You may win the lottery. You may get fired and be unemployed for 6 months (Jessica’s parents are able to support her financially during this difficult time). You may start a business, receiving little income for 10 years before it explodes after that.
My point here is that there are too many factors to make long-term planning a viable option.
I have simply laid out the rules of the game, as they stand at the moment. The landscape in 5 years could be completely different.
It’s not so bad
As Jessica complains to her Dad about her repayments, whilst they’re spending a weekend at their house in the Cotswolds, all he can respond with is “I know darling, I know.”.
But that wouldn’t be my response.
In reality, the system we have in place works very well. You get a service, you pay for it but only when you can afford to do so. This is clearly, in my view, a better system than those across the pond have (exceeding amounts of debt with harsh pay-back conditions). I can see the logic of those arguing for free university education. However, this is not without its flaws and would possibly lead to the degradation of both the quality of the education you receive and the weight that having a degree carries (as they are finding out in Germany).
You get a service, you pay for it but only when you can afford to do so.
Sounds alright to me.
What are your thoughts? Do we have a good system? Let us know in the comments below.
Thanks so much to Haydn too for presenting this post. And do remember to check out his blog for more articles.