Student loan interest and payments – a more informed decision

Welcome to this article which aims to give you the lowdown on student finance. Our mission is to provide clarity and transparency about how student loan interest and payments work. Armed with this knowledge, you’ll be able to make a more informed decision before taking on student finance.

In April 2022, the government announced changes to student loans, increasing the repayment period from 30 years to 40 years, for all students attending university from September 2023 onwards. This cohort has loans under PLAN 5.

Students who started university in 2012 through to 2022, have PLAN 2 loans, repaying them over 30 years. Below is a brief comparison of the two plans.

Student loan interest & payments

Interest is charged on student loans and loan repayments are 9% on earnings above the threshold. The current threshold for Plan 2 loans is £27, 295 per year. This means you will only start repaying your loan once your earnings exceed £27,295 and you will pay 9% on your earnings above the threshold. Interest is charged on student loans based on the retail price index (RPI). The government may intervene and cap the interest rate to avoid excessively high rates, as in September 2022, when they capped the rate at 6.2% for Plan 2 loans.

Types of student loans

Student loans are available for university fees and maintenance loans for living costs. University fees are currently a maximum of £9,250 per year for undergraduate degrees. An important point to note is that maintenance loans are means-tested, based on your parent’s income. What does this mean? The more your parent’s household income is, the less you will receive as a maintenance loan. Parents need to be aware of this and appreciate that if they are higher earners there is an expectation by the government that they will contribute towards their children’s living costs whilst at university. Students from more modest-earning families will receive higher maintenance loans than students from higher-earning families.

HMRC has a handy calculator that estimates how much student finance you are eligible for:

Student finance calculator – GOV.UK (www.gov.uk)

Repayment of loans

The common assumption under PLAN 2 loans is that most students will never pay back their full loan. This is a valid assumption for students who earn modest to average salaries during their working careers. High earning graduates are more likely to repay their loans in full, plus accrued interest. Some parents may consider paying their child’s university fees to avoid incurring student debt. Where students are studying for a degree that will place them in a high earning profession, this is certainly worth considering to avoid accruing loan interest.

Students with PLAN 5 loans, repaying their loans over forty years are far more likely to repay their loans in full. The interest rate on plan 5 loans is lower than on plan 2 loans. Interest is incurred at RPI on plan 5 loans, which means the loan amount increases in line with inflation, so in effect, it is not so much an interest charge but an inflation-tracking adjustment.

The financial details

Compounding interest

When you take student finance, interest is charged on a compounding basis from the date you receive the funds. You incur interest on your loan whilst at university. The first interest charge is based on the initial loan or capital amount. Subsequent interest is calculated on the initial loan amount (capital) plus accrued interest. The interest charge increases slightly every month as it is calculated on the capital balance plus the ever-increasing accrued interest. You are paying compounding interest, which is interest on interest. In year 1 you incur interest on your first year loans, whilst in year 2, interest is incurred on both first year and second year loans. In year 3 interest is charged on three years of loans.

Loan repayments

Repayments of your student loan commence in April after you graduate and are 9% of your earnings over £27,295 for PLAN 2 loans and 9% of earnings over £25,000 for PLAN 5 loans. Initially, your loan payments will be allocated against the interest you incurred while at university. Your initial repayments are likely to be low as most graduates do not earn high salaries for the first few years after finishing university. It is highly unlikely that during your first few years of working your repayments will reduce any of the capital (the original amount that you borrowed). High-earning graduates are likely to start repaying the capital element of their loans further along in their careers. Modest and lower earners with PLAN 2 loans, will probably only ever repay some of the interest and eventually have their loans written off after 30 years. A far higher percentage of graduates with PLAN 5 loans will pay their loan and accrued interest off in full.

Repayment thresholds

Ideally, the loan repayment thresholds should increase annually by inflation, or by the percentage of salary inflation. To illustrate the impact of inflation, assume you have a PLAN 5 loan and earn a salary of £30,000. Your loan repayments are £450 per year or 0.015% of your annual pay. With both a salary and threshold increase of 3%, the new salary is £30,900 and the repayment threshold increases to £25,750. The loan repayments are now £463.50 which is a 3% increase on the original £450 amount. In real terms, the loan repayments remain consistent at 0.015% of the increased salary of £30,900.

However, when the threshold is frozen, loan repayments increase in real terms. In the above example, if the loan repayment threshold remains at £25,000, the loan repayment jumps to £531 on the new salary of £30,900. This is an increase of 18% on the previous loan payment of £450, or 0.017% of the increased annual salary.

The government sets the loan thresholds and as illustrated, freezing them impacts the repayments. When salaries rise with inflation but loan thresholds are frozen, more graduate earnings will fall above the repayment threshold. When loan thresholds aren’t increased by inflation the result is an increased financial burden on graduates in real terms.