Student loans: a lesson in inflation and compound interest
Tom Traill - 28 March 2017
From September, student loans in England and Wales will accrue interest at a rate of more than 6% per annum. The exact rate depends on the March Retail Price Index inflation rate, released on 11 April. Annual RPI inflation was 3.2% in February and the March reading is expected to be similar; adding in the 3% brings the loan rate to 6.2% or thereabouts, as compared to 4.6% for the 2016-17 academic year. This formula was introduced from the start of the 2012-13 year, so will apply in virtually all recent student loan cases. Based on this new interest rate, and the average debt for a newly graduating student of £44,000, they would need to be earning £51,500pa to meet the interest payments on the loan (see figure 1).
A graduate, with average debt, earning an entry-level salary of £23,000pa would suffer a payroll deduction of £15 per month, but accrue interest of £128 per month. If, as we at Economic Perspectives expect, inflation remains elevated for the next few years, then student loans are going to become long-term obligations for all but the highest earners. Most students will continue with their statutory payments until the rapture (or 30 years after graduation, whichever comes first).
The Office for Budget Responsibility has acknowledged that a large proportion of student loans will not be repaid – 45% by their latest estimate. However, as the imputed interest rate rises, this proportion could increase substantially, making a mockery of the ‘loan’ concept. For most students, the loan deductions will last until cancellation, representing a 9% graduate tax on earnings over £21,000. Those earning around £46,000 or more, face a marginal tax rate of 51% - not a great incentive for employees.
Our calculations, in figure 2, suggest that someone starting on an annual salary of less than £23,800 is unlikely to pay off their student loan until it is cancelled after 30 years. These calculations assume that the graduates’ starting salaries follow the typical lifetime profile, as calibrated by the ONS. It also assumes that annual wage inflation and the student loan repayment brackets will move in line with RPI – a generous assumption. We also presume that the RPI+3% structure and 30-year term remain unchanged.
There are already suggestions that the graduate wage premium has diminished. Now the financial advantage is being eroded from the other side as well. Will the UK see fewer school leavers go into university education – will this lower national productivity growth? Will it lead to higher migration? These long-term monthly payments will also affect the borrowing capabilities of graduates – if their disposable income is lowered then their safe borrowing multiples will be too. And how will this extra expense affect the government’s accounts? By around 2040, the OBR has estimated that student loans will be adding over 11% of GDP to net public debt (figure 3), up from 3% of GDP in 2015. Prepare for another furore when the student population wakes up!
Data source: EP Calculations
Data source: EP Calculations
Figure 3: Additions to net debt from student loans: 2016 projection
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