Best ways to pay off student debt

Pressure is mounting on parents to help with the cost of higher education. Many who can afford it would rather pay their child's tuition fees upfront than see them get into debt. But since only around half of all graduates are expected to pay back their loans in full, waiting until after university before helping them out might be a more economic option.

Here we explore whether it makes financial sense for graduates to make additional student loan contributions to reduce the amount of interest they pay, or whether it might be smarter to use the money to invest in an individual savings account (Isa) or a pension.

Whether graduates and their parents should invest their money or make overpayments on a student loan will very much depend on their salary when they graduate, as the following examples show.

Making repayments on a post-2012 loan worth £20,100

A graduate with this level of debt might be better suited to saving any surplus income into a pension or an Isa, as they would have a good chance of securing a higher level of average investment return over the medium to long term. Of course, not all graduates will be in a position to make either an overpayment and/or pension contributions as they are already stretched, but this is where parents can come in.

Students with post-2012 debt who earn more than £21,000 but don't pay higher rate tax, are charged interest equivalent to Retail Price Index (RPI) inflation, which is currently 2.6 per cent. So, for a graduate with £20,100 of student debt, over a 25-year period the monthly cost of servicing this loan would be £91.96 per month, according to Tilney Bestinvest calculations done for Investors Chronicle. In order to make a monthly repayment of £91.96, a graduate would first have to earn £33,261.33 a year.

However, if the graduate or their parents were in a position to make an overpayment of £100 per month on their student loan, the repayment term would reduce from 25 years to 10 years, at which point they would be free to direct more of their savings into an Isa or a pension plan. By reducing the repayment term of the loan from 25 years to 10 years, the graduate would save themselves £4,501 in interest payments, based upon an interest rate of 2.6 per cent.

If, as an alternative, the graduate had invested the £100 per month into an Isa, after 10 years the value would be £13,587 assuming an average annual investment return of 2.6 per cent, which would be sufficient to repay the outstanding balance of the loan. However, under this option, the graduate would have incurred an additional £1,541.38 in interest payments by not making the monthly overpayments.

If, instead, the graduate invested the £100 per month into a pension, they would immediately receive tax relief at source resulting in £125 actually being invested. Assuming an average annual investment return of 2.6 per cent, the value would be £17,321 after 10 years and £53,235 after 25 years, although they wouldn't be able to access pension money until they reach pensionable age.

Making repayments on a £45,000 loan

For a larger loan, investing instead of repaying it faster is likely to make less sense than making extra debt repayments. If a graduate with a post 2012 student loan pays higher rate tax, their will be subject to an annual interest rate of RPI plus 3 per cent, which currently adds up to 5.6 per cent. The required salary to make this level of annual payment would be £58,638.66 a year, based on the 9 per cent repayment amount of earnings in excess of £21,000. Because of this, it may prove to be in high-earning graduates' best interests to use any surplus income or parental donations to make overpayments on the loan, as it could prove more difficult to consistently achieve average investment returns, excluding charges, that exceed 5.6 per cent a year.

Gary Smith, a financial planner at Tilney Bestinvest, said: "Because the loan would be subject to a relatively high rate of interest, it is debatable as to whether or not the graduate would benefit by saving any surplus income in an Isa and or a pension."

If the graduate is a higher-rate taxpayer and can spare around £200 per month for pension contributions, they could take advantage of higher-rate tax relief which would grow their gross pension contribution to nearly £300 per month, and they would also receive an additional £50 per month in higher-rate tax relief via their annual tax return.

In this instance, where the graduate is a higher-rate taxpayer, it could be beneficial to contribute surplus income into a pension plan and then use the additional 20 per cent higher-rate tax relief to make overpayments on the student loan. This creates a win-win scenario as they are saving for retirement and reducing the repayment term of their loan.

Debt repayment and saving options for a graduate earning £33,300 a year and with a £21,100 post-2012 student loan

Debt repayment and saving options for a graduate earning £58,600 a year and with a £45,000 post-2012 student loan

Source: Tilney Bestinvest

*Assumes higher-rate tax relief is paid as additional contribution into loan repayment

**Assumes that Isa monies are withdrawn to repay the loans once the values exceed the outstanding loan balance.