Why Your Student Debt Will Cost You More This Year

It could be in your interests to pay off your student loan sooner rather than later...

Should you pay off your student loan more quickly?

For recent graduates like me, the words `student' and `debt' seem to go hand-in-hand. Unless you're one of the fortunate few who went to university and didn't need help with your finances, then you probably took out a student loan to help take the financial strain out of university life.

If so, you're in for some bad news. The interest rate charged on these loans has just doubled from 2.4% a year to 4.8% a year - which means your student debt just got a hell of a lot more expensive.

Here at the Fool we've said time and time again that mathematically it makes sense to pay off your debts before you start to save. But does this also apply to student loans?

In our MoneyTalk podcast this week, David Kuo, Neil Faulkner and I have a bit of a debate about this. The fact is, paying off my student loan is not my top financial priority and at the moment I prefer to save instead. So am I right or wrong to take this approach?  

Young, educated and in debt

According to various polls, today's graduates saddle an average debt of between £11,000 to £16,000. Most of this debt will be owed to The Student Loans Company, a public sector organisation set up by the Government to provide and administer student loans, which are offered at a special interest rate tied to rate of inflation.

This means that the amount repaid should be the same value as the amount borrowed, in real terms (i.e. in relation to wages and the price of goods). So it shouldn't matter how long you take to pay off your debt.

What's more, student loans are unlike conventional loans in that you only have to start making payments when you are earn over £15,000 a year. Above this threshold you automatically pay 9% of your earnings through your employer's payroll - so somebody earning the average graduate salary of £18,000 would repay £270 a year or £22.50 a month.

If you stop working, you are not required to make any repayments. In addition, the debt is cancelled if you become permanently unfit to work.

Paying up

How much does a student loan cost? Let's have a look at the figures for a typical graduate whose loan repayments started in April this year. 

Let's say, for example, Mr Typical started studying at a London university in 2003, and was able to get the maximum loan amount available. He then managed to a job immediately after leaving university, paying him the average graduate salary of £18,000 a year. Loan repayments automatically began six months later.

As this table shows, despite Mr Typical paying back £382.50, the debt would have actually grown by a whopping £717.35 over the two years since he left university.

Why? Because the annual repayments do not even match the interest charged each year - never mind actually paying off the capital debt that is owed.

You'd need to be on a starting salary of at least £23,200 before your payments would actually start to reduce the capital of a loan this size. Alternatively, you'd need to find that extra £465 a year (£38.75 a month) to make up the difference between what you are being charged in interest and what you are paying back.

However, it's not all doom and gloom. It's worth remembering that, despite the increase in interest rates this year, a student loan is still very cheap and the current interest rate of 4.8% is the highest it's been since 1991 (the average loan interest rate over the past ten years is 2.79%). It would be hard, if not impossible to find a personal loan on the high street that could beat it.

Stay In Debt?

So, back to our original question: should you pay off your student loan more quickly than you have to?

First of all, if you have any other debts - such as other loans, credit cards, store cards or an overdraft which is not interest free -- it's advisable to pay these off first, because the interest rate charged on these debts is likely to be significantly higher than the interest rate charged on your student loan.

But if you don't have any debts -if, in fact, you have some savings or can afford to put aside some money every month -- should you use it to pay off your loan?

If you can stick the money in an ISA that pays more than 4.8% interest, then it makes sense to do so, because you will be earning more interest on your savings than you will be paying on your debt.

If, however, you have used up your ISA allowance, you should think carefully before putting the money into a savings account. Even if you get the most competitive, market-leading instant access savings account, paying 6.3%, it may not be the right decision to save your money, because you have to pay tax on the interest.

If you are a higher-rate tax payer, you would receive just 3.78% net, and would be better off paying back the loan instead of saving (you can find out how to pay off your loan quicker with additional payments by visiting Directgov.co.uk). However, a basic rate taxpayer, who would receive 5.04% net, would be better off with a savings account.

But hey, let's look on the bright side. However much your student loan costs you and however you decide to pay it back, at least you can look back on your years at university and say: I spent that money wisely. Right?

More: Should You Overpay Your Student Loan?