Student finance in England: Impact of increasing the loan interest rate

Paul Bolton

The Government plans to publish a conclusion to its review of post-18 education and funding in autumn 2021. It’s widely expected it will propose the largest changes to student finance since 2012.

This Insight looks at how an increase in the maximum interest rate would affect the repayment of undergraduate loans.

Under the current system, interest is charged on loans at rates between the RPI (Retail Prices Index inflation) alone and RPI plus 3%.

Here we mainly look at the hypothetical effect of a 1 percentage point (ppt) increase and find that it would lead to higher repayments from richer graduates (borrowers), mainly men, in their 40s and 50s.

If people repay more because of higher interest, it would cut the cost of loans to the taxpayer; a 1ppt increase could reduce it by around £0.6 billion. However, there would be a greater incentive for richer borrowers to repay earlier and this could reduce the size of these savings.

Only those with higher earnings pay back more with a higher interest rate

The impact of a 1 ppt increase in the interest rate would mean that the average repayment per borrower would increase by £1,500 or 5.2%.

However, this increase is not spread evenly across borrowers. Only those with higher earnings pay back more. The number of borrowers who repay their loan in full would drop from 22% under the current system to 18%.

The chart below summaries the main effects of an increase in the interest rate. It looks borrowers based on their earnings deciles and at overall financial flows. The data is from the Institute for Fiscal Studies (IFS)’s Student finance calculator. All figures are shown in present value terms. This adjusts future repayments for inflation and the Government’s cost of borrowing to give their value to the Government at the present time.

Charts showing the impact of a one point increase in the interest rate on graduate repayments and the cost of loans — Source: Student finance calculator and House of Commons Library calculations

The Resource Accounting and Budgeting (RAB) charge is the difference between the amount lent to a cohort of students, and the present value of their repayments as graduates. The IFS forecasts that this will be 44% under the current system. The increase in the interest rate would reduce it to 41% and means the overall cost of loans to the taxpayer falls by £0.6bn.

Why do repayments change in this way?

Loan repayments are income contingent. Currently, borrowers repay 9% of any earnings above the repayment threshold (£27,295 in 2020/21). Repayments are made until the amount borrowed and interest is repaid, or after 30 years, when it is written off.

Increasing the interest rate only affects the 22% of borrowers who would repay their loans in full under the current system.

They are currently forecast to repay their loan principal and interest at the current rate in less than 30-years (the loan term). They would therefore have some of the loan term left to pay some or all the additional interest charges from a higher rate.

A higher interest rate increases the amount they owe, extends the duration of repayments and the total amount they repay

There is no impact on the remaining 78% of borrowers. They would not repay their loan and interest within 30 years at the current rate. A higher rate would add to their interest charges, but repayments are income contingent, so all the extra interest charge is also written off at the end of the loan term. Their repayments remain exactly the same and would do so for any increase in the interest rate.

The timing of extra repayments

The additional interest is repaid by richer borrowers by extending the time they repay, not in higher monthly repayments. This means the extra repayments do not happen until these borrowers are typically in their 40s or early 50s.

The following chart looks at the timing of overall repayments and shows that the additional repayments do not start until 15-20 years after the loans become due.

Source: IFS Student finance calculator and House of Commons Library calculations

How does the impact vary between men and women?

Average graduate earnings are higher for men and more men are expected to repay their loans in full under the current system. This means that a change in the interest rate has a greater effect on average for men.

The following charts show that additional repayments start further down the male earnings scale. Only the top two deciles among women see any real increase in repayments.

Overall, male borrowers would have an average increase in repayments of £2,800 (6.4%) compared to £600 (3.0%) among female borrowers.

Charts showing how the impact of an increase in the interest rate differs between men and women — Source: IFS Student finance calculator and House of Commons Library calculations

A greater incentive for early repayment?

A higher interest rate means richer borrowers would pay back more.

Those in the top two earnings deciles are already expected to repay more than they borrowed, even in present value terms. This means the taxpayer makes a ‘profit’ on loans to higher earners.

Higher interest rates increase this ‘profit’ further. For instance, the IFS model forecasts that with a 1ppt increase in the interest rate, the present value of repayments from the top decile will be 37% more than the amount they borrowed.

In 2019. the independent Augar Review into post-18 funding recommended that these ‘overpayments’ should be limited to 20%.

Higher interest rates create an incentive for those on higher earnings to repay their loans early and avoid interest payments. Some who expect to be high earners may not take out student loans at all, but this would be riskier as their future income is less certain. It would generally be those from wealthier families who were more able to take advantage of this

If substantial numbers repay earlier, then the savings to the taxpayer from higher interest rates would be reduced. Increasing the interest rate also makes the system look less like one based on loans (where repayments are linked to the amount taken out) and more like a quasi‑graduate tax.