At the start of September, the student loan interest rate increased from 5.4% to 5.6%. This has caused a lot of concern. However, the situation doesn’t seem to be as bad as many initially thought.
The interest rate increase applies to Plan 2 student loans, all English and Welsh students who started university on or after 2012. Some EU students also have Plan 2 loans, so it may be worth checking.
What is interest and how is it calculated?
Although significantly lower than the interest rates on other UK loans, student loans still require interest payments. Interest is a percentage of the overall loan amount that has to be paid back on top of the amount of money borrowed. It is often quoted annually, with the rate changing year on year. The whole premise around interest is that the lender should be compensated for offering their money.
Student loan interest rates change every September and are partly based on the Retail Price Index (RPI) inflation measure from March of the same year. Student loan interest is set at RPI +3% whilst the borrower is still at university. Therefore, if RPI changes, the interest rate will also change for that year.
This March, RPI was up 0.2% at 2.6% instead of the previous 2.4%. When 3% is added, the interest rate became 5.6%.
After graduation, the way interest rate is calculated changes and is instead RPI + up to 3%. The amount of interest each person pays after graduation depends on earnings. This can vary from paying interest solely at RPI level without the added 3% if you earn less than £26,575 a year, to the full RPI +3% for anyone earning over £47,835 a year. For annual earnings between these values, the interest rate will lie somewhere on the scale between RPI and RPI +3%.
When does repayment start?
Student loans do not start being paid back until the April after graduation and when the borrower hits the repayment threshold of £26,575 a year. In other words, the borrower has to be earning a certain amount of money before repayment starts. The rate at which the money is paid back also depends on annual earnings. The higher the salary, the faster the rate of repayment will be.
Why has there been concern?
Many are frustrated that the interest rate increase is occurring whilst those on Plan 1 loans are paying 1.1% in interest this year.
Plan 1 loans are for current Northern Irish and Scottish students or those who went to university between 1998 and 2011. The interest rate on this loan tends to be lower and is dependent on whatever is lesser out of the RPI and Bank of England base rate +1%.
An additional source of frustration stems from the fact that if student loan interest rates were based on RPI in April or May, there would have been “an interest rate drop from September” says Helen Saxon at MoneySavingExpert.com. This is because the coronavirus outbreak caused a drop in inflation rates.
Why we have to look at the bigger picture
It is important to put this increase into perspective. Interest rates can decrease as well as increase. Between 2018-2019 Plan 2 student loan interest was 6.3% before it decreased the following year.
Additionally, any unpaid money will be written off after 30 years. Only 17% are estimated to pay back their student loan in full. With this considered, any alteration to interest rate makes little difference in the long run. Therefore, as noted by Save the Student, increasing interest is more of a psychological issue than a financial one. Only if someone has borrowed a small amount or is a high earner will it become more likely that more of the student loan will be paid back with interest rates then making a difference.
It is also reassuring that the repayment threshold for Plan 2 loans is increasing to £27,295 from April 2021; for those worried about increasing interest rates and potentially having to pay that bit extra, it will only come at a time when the borrower is even more financially secure.