Martin Lewis VIDEO: Should you pay off your Plan 1 student loan?
If you started university between 1998 and 2011 in England or Wales, or since 1998 in Scotland and Northern Ireland, you'll have a Plan 1 student loan. While much is written about whether those with savings should overpay the current English Plan 2 student loans, there's little out there about Plan 1. I wanted to change that, so here's a video explaining how to decide...
Here's a transcript of the video...
Should you pay off your student loan? It's a question I'm asked all the time, often because people have looked at their statements and are going: "Ah! The interest keeps adding up, what should I do?", or because life's going well, you've got a little bit of spare cash and you want to know what to do with it.
Now I've answered this question many times before, but normally I talk about Plan 2 student loans. Those are the ones for current students in England or Wales, or anyone who started in England and Wales since 2012.
But lots of people are on Plan 1 loans and I get asked this too, so this video is just about those loans. Now Plan 1 applies to anyone who started university anywhere in the UK between 1998 and 2011, and Scottish and Northern Irish students who started from 2012 onwards, including those there currently.
It's important to understand most of the messages in the media are about Plan 2 loans, but the Plan 1 loan works quite differently, which means the logic of whether you should pay it off is different too.
Now with the Plan 2 loans – remember English and Welsh students from 2012 onwards – the borrowing's big and most people won't repay what they borrowed plus the interest in full before the 30 years when it wipes. In which case, it's probably not a good idea for most to try and overpay – and I've got guides on the site where you can go and read that.
But let's just examine some of the differences between the Plan 1 loan and the Plan 2. First of all, with Plan 1 loans you borrow less because tuition fees tend to be lower or non-existent than the Plan 2 loans. You also have a much lower interest rate, so the debt won't grow as quickly, and you repay much more.
On Plan 1 loans, your repayments are set as 9% of everything you earn above £18,935, whereas with Plan 2, it's 9% of everything above £25,725.
In other words, on exactly the same income, people on Plan 1 loans pay much more each year. You put all those things together – lower borrowing, less interest and you're repaying more – and it means you are far more likely to clear what you've borrowed before the debt wipes. As for when the debt wipes, it's complex. It depends in which county you went to university and when you started. It could be 25 years after you graduated, 30 years after you graduated or when you hit age 65. You need to go and look that up.
Now this concept of whether you will clear what you've borrowed plus interest before the debt wipes is crucial for making the decision of whether you should overpay or not.
If you're unlikely to clear it – which for Plan 1 loans is only going to be those people on relatively low incomes – then the interest that you see on your statement isn't real, because you would only pay all the interest if you clear it before the debt wipes. Otherwise, you're going to pay less than all the interest and possibly less than you borrowed in the first place.
But, because most people on Plan 1 loans will clear everything that you borrowed plus the interest before it wipes, that means your interest on your statements is real. So we can do a direct comparison between it and what you'd earn saving or what you’d earn with other borrowings. So let's investigate that interest rate now.
Now, the interest rate on Plan 1 loans is somewhat complicated because it's based on the lower of two figures, so you have to look at two to decide what it’s going to be. It's either the rate of inflation – the RPI rate which changes every September based on inflation the prior March – or the Bank of England base rate +1%. Now that's currently 1.75%, whereas from September 2019, this one is going to be 2.4%. So, 1% plus the Bank of England is the interest rate that you pay. This is crucial. As you can see, the maximum interest you will ever pay is the rate of inflation, and that theoretically means there is actually no real cost to your student loan. Now that might be really confusing, so let me try and explain it to you.
Now inflation is all about the rate at which prices rise. So something will cost you more in a couple of years than it does right now, but then people will tend to earn more in a couple of years than they do right now, and everything goes up in a similar level. You know, 200 years ago someone who earned £100 a year would be very rich, they wouldn't be rich now. It's all about relative costs.
So to make this easy, let's imagine when you go to university your tuition fees and maintenance loan total £10,000 – enough to buy you a hundred £100 shopping trolleys worth of goods. There you go. The next year, those shopping trolleys might all cost £101, the year after £102, and then £105, and then £110. But because your rate of interest is set, at most, at the rate of inflation, all you'll ever have to repay back is, at most, a hundred shopping trolleys' worth of goods at whatever that costs in the future, based on whatever earnings are in the future, and that’s the definition of no real cost.
Now you'll remember I explained that your interest rate is set, at most, at the rate of inflation, or it could be the Bank of England base rate +1% as it is right now, which is lower than inflation. And that actually means, in technical terms, your student loan is shrinking.
So if we were to take this purely on a theoretical analysis, you definitely don't want to overpay your student loan, because the debt's shrinking, not growing, in real terms. But that's the theory, so let's move on to practice.
In practical terms, what you have to analyse is not the cost of your student loan vs inflation, but the cost of your student loan vs alternative uses of cash. So if you can afford to overpay it and you're likely to clear the loan before it wipes, what else could you do with the money?
Now it's important to understand your student loan is the cheapest long-term loan you will ever get, set at a maximum of the rate of inflation and it has better terms too, so that gives it a good head start. The first question it asks you is: “In the future, will you ever need other forms of commercial borrowing?” A mortgage, for example, or a personal loan. Undoubtedly, they will be more expensive than your student loan. You know, a standard mortgage rate is 4-5%. OK, you'll get a cheaper deal earlier on, but it'll be way more expensive than the student loan is right now. Personal loans could be 10-15%, credit cards 20%, and I won't go into hideous forms of lending that are more expensive than that.
So what you wouldn't want to do now while you've got spare cash is overpay your student loan, but then have to borrow it back from a mortgage or a credit card in future when you need it. So if those are plausible events, don't overpay your student loan, keep the cash liquid.
But more so, even if you wouldn't be borrowing in the future, the fact is the student loan interest rate on Plan 1 loans is currently 1.75%. You can earn 2% interest in a one-year fixed savings account – at the time I'm filming this anyway. So you can actually earn more money in savings than your student loan is costing you. And that clearly means, both because it gives you a safety net – you know, put the cash in savings, you're both earning more than the debt's costing you, and in case you need to borrow back in future, you've got a safety net – I certainly would not be paying off a Plan 1 loan.
Now you might say to me: “Hold on. What about if in the future, inflation goes up and savings rates don't keep up, so the interest is costing me more than I can earn in savings, and I don't want to borrow anywhere else?”
Well in that case, all I'm suggesting here is you lock your money away for a maximum of one year. So at the end of that one year, if the scenario has changed and you want to clear the Plan 1 loan, you can.
The only other caveat could be if we forget this pure financial logic, which is what I'm basing it on, and also look at you as a person. Do you trust yourself? Do you tend to splurge and have bad impulse control? In that case, you might want to consider – even though it doesn't add up – overpaying your student loan, because at least then the money is doing something good.
But do remember, once you make the decision to overpay, you can never change your mind. So if in future you were to lose your job and start earning less than that roughly £19,000 threshold where you start to repay, so you have no student loan repayments to make, you wouldn't then be able to take this money back.
So in general, don't overpay your student loan on a Plan 1. And if you're in one of those rare circumstances where you think it might be worth doing, think very, very carefully, because once you do it, you can't change your mind.
I know that's all been complicated. I've tried to take it quite slowly and I hope it all makes sense. I expect some of you might want to watch it through a couple of times, and I will put a transcript of this in my blog, so you can read it through slowly.
But if I go back to it, my big summary – if you ask me: “Should I overpay my Plan 1 student loan?” For most people, the answer is no. Put it in top savings instead.
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