I recently began my first job as a graduate, and have decided to begin repaying my student loan as slowly as I can. I could voluntarily increase my repayments, but I choose not to for now. My decisions the product of distorted incentives and sound economic reasoning.
As a student I was fortunate to enjoy a relatively comfortable financial position. However, instead of borrowing only what I needed, I borrowed as much as I could.
You may wonder why someone would voluntarily take on unnecessary debt. The answer is simple: my student loan was accruing no interest as I studied. I was borrowing extra, putting it in the bank, and using the stream of interest payments to support my lifestyle.
I intended to give the money back as soon as I finished studying. But then my plan changed. In 2005 Labour decided to buy the student vote by extending the interest free criteria on student loans. My loan would now remain interest free, even when I entered the workforce.
My new plan was to keep the money for as long as I could, and only make the minimum required loan repayments. Inflation would slowly erode away the value of my outstanding loan.
My simple strategy was complicated following the 2008 general election. The newly elected National government kept interest free student loans, but introduced a 10% early repayment bonus (for voluntary repayments of at least $500). This policy was designed to speed up student loan repayment rates.
My problem now had two competing dimensions. I still had the incentive to delay repayments and let inflation erode away the value of my loan, but then by doing so I was forgoing potential repayment bonuses.
To solve my dilemma, I built a spreadsheet model. Its recommendations are simple. I should make the minimum required repayments for now, but in a number of years’ time repay the remaining balance of the loan in full with a single voluntary repayment.
The exact timing and magnitude of my voluntary repayment depend on the assumptions I feed into the model, however the general specifications of the strategy remain unchanged. At any point in time, a voluntary repayment is only logical if the compounded return from investing the money is less than the 10% voluntary repayment bonus (note this strategy differs if one holds other debt).
For example, let’s assume you are three years off fully repaying your loan, and have the option of investing money at 4%p.a (after tax). Then a voluntary repayment would not make sense as investing the money would yield a compounded return of 12.5% versus the 10% voluntary repayment bonus. However, if instead your timeframe is only two years, then a voluntary repayment is optimal as your investment would only yield 8.2%.
The above rationale also suggests that as soon as it’s optimal to begin making voluntary repayments, don’t just make the minimum required to get the bonus, pay off the loan in full (assuming you have the financial means). At this stage the 10% government bonus is the best return you can get – you may as well chase it with all you can.
Using this strategy, an average bachelor level graduate would take 8 years to pay off their student loan, instead of 10 years by only making minimum repayments. This is assuming they graduate with a $27,000 loan, have an average graduate starting salary of $38,500, wage growth in line with historical averages, access to investments yielding 4%p.a. (after tax), and in the eighth year make a $6,060 voluntary repayment. Even though, this strategy would only save the borrower $175 (present value terms) over making the minimum required repayments, the borrower would be free of repayment obligations two years faster.
If the borrower was lucky enough to have not needed a loan, but had still taken the money and invested it, then my strategy would earn theme whopping $2,400 (present value terms) over repaying the loan in full upon graduating.
Strategically repaying a student loan is clearly cheaper for the individual borrower. However, any savings the borrower makes reduce the government’s book value of the loan. While in isolation the impact of these actions is infinitesimally small, the costs to society quickly mount if others follow similar strategies. And people do, this year alone the government wrote-down the value of outstanding loans by more than 10%.
The problem is that the student loan scheme suffers from misaligned incentives. A loan should be a means of funding an education, not a loophole to exploit. The government must reintroduce interest on student loans. This would remove the incentive for students to borrow more than they need, and speed up repayment rates once they enter the workforce. Interest free student loans were an expensive giveaway to those in society with the highest earning potential. It is time that this expensive backhand subsidy is removed.
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