The Finumus household is enjoying its first interaction with the student loan scheme in 30 years.
Our eldest is (hopefully) off to university in the autumn. Our youngest will be going two years later.
Just to keep things interesting, the government is completely overhauling [1] the student loans system for the 2023 intake. Hence we get to do a little natural experiment with our finances.
We’ll skip over the debate about whether university is a good use [2] of time and money. Our children are going, and that’s that.
The question for now is: “Should they borrow the money or not?”
Enter the student loan
Let’s first acknowledge how fortunate we are that whether or not to take the student loan is even a question.
Most families don’t have a choice. The only way their children can afford to go to university is with a loan. This makes the value-for-money calculation that much harder for them.
But our kids go to public (that is, private) school. The annual cost of their education will actually be marginally reduced once they are at university, compared to the current status quo, even if they borrow nothing.
So we can afford to support them – in terms of both fees and maintenance.
However we’re going to have them borrow the maximum amount of student loan.
Like everyone else they’ll be saddled with crippling student debt when they graduate!
Does this seem a bit mean to you?
Let’s look at the reasoning.
How the student finance system works
Students are expected to borrow money from the government’s student finance scheme to fund their university education.
They can borrow to cover all the fees (£9,250 p.a. ) and also some element of maintenance – ranging from about £4,500 p.a. to about £12,000 p.a. – depending on various complicated criteria, including family income.
(This is if you reside in England and are attending university in England. Otherwise the rules are more complicated).
Repayment works like a hypothecated, limited amount, graduate tax.
- Under the current scheme, you have to pay an additional 9% income tax over a certain threshold, until you’ve paid the loan back or until 30 years has passed. At that point the student loan is written off. Interest charged is roughly RPI+3%.
- With the new (2023) scheme, the earnings threshold is lower, the interest rate is lower (roughly RPI), and the term is 40 years.
Crucially, for us, you can also repay early with no redemption penalty.
According to the IFS [3], the 2023 changes will mean that far more graduates will repay their loan in full (75% vs 25%) but those students who would be paying it back in full under both systems (that is, higher earners) will benefit under the new scheme. This is because the interest rate is lower.
More lower earners, who might have escaped repayment under the old system, will be caught by the new lower earnings threshold. These people will end up worse off.
The change then is highly regressive – if you are measuring only within graduates.
If you’re thinking about the wider tax base, it’s not quite so clear – because arguably the change reduces the tax burden currently falling on those who don’t go to university.
The stated intent of the changes is to encourage students to read subjects that lead to higher-paying careers.
Any side effect of discouraging some from going at all the government doubtless sees as an extra bonus. After all, universities teach young people to think for themselves, and turn out lefty-liberal-remainer-voting ‘experts’.
But this is a finance blog not a political one.
Let’s take the system as we find it and – well – think for ourselves.
Gaming the system
Back in the halcyon days of positive real interest rates, low asset prices and cheap student debt – when your correspondent was at university – gaming the system was easy.
The student loan was only required to cover maintenance (fees were paid by the state – imagine) and the interest rate charged was very low.
Although my parents insisted that they didn’t want me to get into debt and hence paid for my maintenance, I of course borrowed the money anyway and used it to speculate in the stock market.
I could even have stuck it in the bank and come out ahead, too. (Admittedly you did have to avoid the temptation to spend it all in the union bar).
But things are more complicated under today’s shifting regime [4]. The loan is dearer than it was for me, for a start.
However even if you can afford to sidestep the student loan altogether and just have your kids pay-as-you-go (PAYG), you might still want them to get into hock by maxing out their student loan, and then you (as a family) stash away the equivalent sum borrowed elsewhere.
To be clear, we’re suggesting that on graduation, our graduate will be in one of two positions:
[5]Which one is best? The net positions seem identical.
However there are two reasons why you might prefer to borrow:
- Positive carry: it makes sense to take out the student loan if you can earn a low-risk post-tax return that’s higher than the interest rate on the loan.
- Loan write-off: if our young graduate isn’t ever going to have to pay the loan back, then that’s a win.
We’re not going to spend much time on the first reason. Earning a sufficiently high yet near-risk-free rate of return will be extremely difficult under the current scheme, although it might just be possible under the 2023 scheme, with its lower interest rate.
Your required rate of return also depends on your individual tax circumstances. It’ll be harder if you’re already filling up everyone’s ISAs [6] and SIPPs [7] to the max, for example, because your return will be taxed. You’ll have to do your own maths, based on your personal circumstances.
Borrowing also adds unnecessary complexity and leverage to the family’s affairs, so that’s a demerit.
All things considered, for us the positive carry argument doesn’t stand on its own.
It comes down to the second reason. Are my kids really going to have to pay the loan back?
Reversible decisions
As Jeff Bezos famously pointed out in his 1997 Amazon shareholder letter [8], it’s much easier to make reversible decisions.
The student loan can be paid back at any time. This means borrowing the money is an easily reversible decision.
At any time after graduation our family can collapse the ‘Borrow’ row in my table above into the ‘PAYG’ row. We simply take money from our savings and write a cheque to the Student Loans Company to do so.
However we can’t go the other way round. Once we’ve not-borrowed the money, there’s no going back and asking to borrow it again.
Therefore, we should borrow the money. It’s what’s known in finance parlance as a free ‘real option’:
[9]We’d be foolish not to take it.
Little darlings
If you’re in a position to make a decision like this, you’re likely over-estimating the probability that your child will have to back the loan in full.
We know that between 75% (current scheme) and 25% (new scheme) of graduates won’t repay the loan in full.
But of course, your kids will, right?
You’re likely a high-earning university graduate yourself.
So you imagine that your children are going to have fulfilling, well-remunerated careers.
They may well do so. But they might not.
Stuff you don’t want to think about
I was fortunate enough to attend one of Britain’s most elite universities – the sort of place that churns out Prime Ministers and Fortune 500 CEOs.
At a recent gathering of some old college friends, conversation turned to the range of outcomes that our cohort of about 150 had experienced. This led me to consider whether we all would have paid back the student loan if we’d been borrowing under today’s rules back then.
In our sample there’s a large rump of successful middle-class high-earners, a few centimillionaires, and a bus driver. All of them would likely all be paying back their loans.
Then we have people who have worked their whole lives for charities on fairly low pay – mostly women. Some had a fairly short career because they decided to prioritize family. Others became artists or poets.
They likely wouldn’t be paying back their whole loan.
We also have a few who wouldn’t have had to repay any of the loan at all. The ones who suffered mental and physical health problems, addiction, family break-ups, legal problems, or just unlucky employment choices that materially impacted their ability to earn. Their careers sort of petered out before they really got going.
Finally, and I’m sorry to bring this up, but it is a reality – we have those who didn’t make it at all.
One didn’t get to graduation. Three died before they were 30: traffic accident, drowning, cancer.
I concede this is a set of anecdotes, not a representative sample. But there it is. Sometimes things don’t go to plan. It doesn’t matter how middle-class you are, how good a university you go to, or how much money you have. Nobody is immune to these possibilities.
More happily, we also had a few who permanently emigrated. They wouldn’t need to pay back their loan. (I know nowadays in theory you would, but in practice if you’re permanently emigrating then what are they gonna do about it?)
They’ll change the rules
So there you have it. As a family, you should have your children borrow the money, while you squirrel away in a savings account whatever you would have spent. Then simply decide later whether to pay it back.
You could choose to repay the loan the day they graduate or a decade later. Taking out the student loan is an easily-reversed decision that provides a fairly low-cost insurance policy against bad outcomes for your child.
Finally there’s the other side of the equation. The rules will change – probably for the worse, but possibly for the better.
The whole system could be replaced with a graduate tax, which they’d be paying anyway. This would likely incorporate some sort of forgiveness of the existing debt as part of the process.
The fact is 30-40 years is a very long time. Anything could happen. The US [10] paused loan repayments during the pandemic. Some politicians are now advocating student loan forgiveness.
Just whatever you do, don’t let your spunky offspring splurge the borrowed money away in a future resurgence of YOLO madness [11].
If you enjoyed this, follow Finumus on Twitter [12] or read his other articles [13] for Monevator.