How student loan repayments work (and why clearing the debt could be a bad idea)

Going to university marks many firsts: the first time away from home, the first step on the path of a new career and, in many cases, the first major loan of adult life.

On average, students are now forecast to accrue up to £50,000 in debt during their time at university, according to the Institute of Fiscal Studies. The huge figure combines annual tuition fees of up to £9,250 a year, maintenance loans and loan interest charged while studying – but the debt can get far higher if you take more than one course.

While beginning your working life saddled with so much debt is not an appealing prospect, a student loan doesn’t operate like other typical loans, and repaying it early may not be in your best interests. For one thing, if the debt is not repaid at the end of its maximum term, it’s wiped off. 

High earning graduates, however, may end up repaying a six-figure debt over the same period.

How do student loans work?

“A student loan works more like a tax than a typical loan,” said Tom Allingham of student finance website Savethestudent.org. 

“Payments are only made when the graduate earns over a certain amount of money – and even then you only have to repay a proportion of your income over that threshold, which makes the payments more manageable. 

“The loan doesn’t impact your credit score, and if you’re out of work – and therefore aren’t making any repayments – you’ll never get the bailiffs knocking at your door.”

There are different student loan plans; the one you’re on depends on when you went to university, and in which country.

Students who started university in England between 1 September 2012 and 31 July 2023 will be on Plan 2. 

Under Plan 2, students will start repayments from the April after their graduation, paying 9pc on earnings over annual earnings of £27,295. If you earn less than this threshold, you won’t pay anything – but your loan will still accrue interest. Any loan that’s left after 30 years will be written off.

Inflation and interest rates

Student loan interest rates are usually tied to the March Retail Price Index (RPI) measure of inflation. However, high inflation forced the Government to step in to temporarily change the way interest was calculated.

Instead of the usual RPI-linked structure, the Government capped the interest rate from September 2023 at 7.3pc. It’s reviewed monthly, and is currently at 7.7pc (as of March 2024).

Any parents worried about these rates, which still exceed most mortgage repayments, should think twice before stepping in to help. 

Edmund Hastie, of wealth manager Quilter, said: “The student loan interest rate can be misleading. Unlike other types of debt, the interest added to the loan isn’t necessarily the interest paid, as it depends on the borrower’s future earnings. 

“This means some borrowers won’t repay any interest, and most won’t earn enough to repay anywhere close to all of it.”

If inflation takes a tumble, the usual method for working out student loan interest may return. 

In a low-inflation economy, the ordinary rate of interest charged to students while at university is RPI + 3pc. After graduating, the interest rate depends on how much you earn. For someone earning £27,295 or less, interest is based on the RPI rate, but no payments are made. 

If you earn more than this threshold, the interest rate increases up to RPI +3pc until you earn £49,130. At this point the interest rate is capped.

From September, students will come under the latest iteration of student loans, Plan 5. Interest rates have been lowered, but the starting salary at which repayments are taken has also been lowered. And, crucially, loans are now written off after 40 years, rather than 30. Martin Lewis, founder of Moneysavingexpert.com, says this means many typical graduates will be paying 50pc more than under the pre-2023 system.

Who should pay off their student loan early?

Only around a quarter of graduates under the current Plan 2 system will repay their loans in full, according to the Institute of Fiscal Studies. Under the new Plan 5 system, this rises to more than 50pc, according to Moneysavingexpert.com.

Trying to work out if you’ll be one of the 25pc to repay your debt within the 30-year timeframe, or if you’ll have a large chunk wiped off, is “nigh on impossible”, says Laura Suter, of investment platform AJ Bell.

“It depends on your starting salary, how much of a pay rise you see over your career, whether you take any career breaks and whether you work part-time at any point,” explains Ms Suter.

According to projections calculated by AJ Bell, a graduate with a starting salary of £25,000 (below the repayment threshold), which rises 3pc each year, could end up repaying nothing at all.

Therefore, after 30 years, £127,000 of student debt would be wiped out. However, this would also be dependent on the repayment threshold increasing with average annual earnings each year – which isn’t a given, since it’s been frozen at £27,295 since 2021-22. 

The landscape is even more complex for higher earning graduates.

Joining the workforce on a £50,000-a year salary will see you repay £106,000 and means you will have £56,000 wiped out at the 30-year mark, assuming your salary increases by 3pc each year.

Add two year-long career breaks in your thirties into the mix and you will repay £91,000 and will have £90,000 wiped out after 30 years.

To repay the entire loan in 29 years, a graduate would need to earn a starting salary of £56,000 and be awarded a 3pc rise each year. Without any breaks in their career they would end up clearing a debt of £124,000. 

Add in two £5,000 pay rises in the first 10 years of your career and you would repay your £50,000 student loan in 23 years, repaying £106,000 – £18,000 less than the previous example, thanks to the savings you’ll make on interest. 

Ms Suter adds: “If you know you’re going to be a high-earner and you, or your parents, have the spare money, then paying off the loan when you graduate could save tens of thousands of pounds in interest charges.

“But if you’re just making partial repayments, unless the repayments each month more than cancel out the interest accumulated on the loan, you could find that you end up repaying the same amount of money – in addition to the lump sum you’ve paid off.”

It’s worth remembering that your repayments are linked to how much you earn, so overpaying will not reduce the amount you must pay each month.

Mr Allingham says graduates who make partial repayments risk wasting their cash: “Our advice would be, if you have a spare £10,000 to £20,000 you’re much better off putting that money towards a deposit for a home or using it to support another financial goal.”

Downsides to leaving your debt

While student loan debt doesn’t affect your credit score, repayments will be considered as part of mortgage lenders’ affordability assessments, and may reduce how much you can borrow. 

However, as graduates only pay back 9pc of their earnings above £27,295, the monthly repayments are low and in proportion with your salary.

Graduates heading into certain professions, such as law or medicine, are often offered more generous mortgage terms because their income will increase after their training is complete. This could counteract the impact of your student loan payments.

Invest – or save the money instead

Before parents dip generously into their savings to pay off a chunk of student debt, they should consider other ways that they can help their child.

Instead of paying off a £50,000 debt that your child may never need to fully repay, you could invest the equivalent lump sum for them. Making no further contributions, you would have a pot worth £352,000 after 40 years – when your child may be looking to retire – assuming growth of 5pc a year after charges, according to AJ Bell.

Investing the £50,000 lump sum for 10 years, until your child reaches their early thirties and may want to buy a house, would mean you could contribute £81,500 towards their purchase, assuming that same 5pc a year growth.

Parents could also decide to take advantage of the incentives offered by the government-backed Lifetime Isa, once their child has opened an account.

Depositing the maximum amount of £4,000 a year into a Lifetime Isa will also earn the maximum government bonus of £1,000 a year.

Doing this every year for the 10 years after graduation, assuming an interest rate of 3.5pc, would give the child savings of £65,709 to spend on a house deposit, according to Quilter – which would only have cost the parents £40,000.

Myron Jobson, of stockbroker Interactive Investor, said: “Regardless of whether you decide to overpay a student loan, it is important to ensure that your finances are in good health before putting in more than the minimum. 

“This means paying off any outstanding high interest debts and maintaining a healthy rainy-day fund of between three to six months’ salary if you can afford to.”