Is it better to pay off your student loan or top up your pension?

Oli West

by , Senior copywriter

at PensionBee

28 Oct 2021 /  

28
Oct 2021

A graduate wearing a mortarboard looks out towards the city

Graduates in England left university in 2021 with an average student loan of £45,000 (the highest amongst the UK’s four nations). Meanwhile, the average graduate salary was just £24,000. So it’s no surprise that many of today’s graduates have resigned themselves to paying the bare minimum and waiting for it to be written off after 30 years.

But what if you want to free yourself of student debt sooner? Does it ever make sense to pay off a student loan early? And wouldn’t you be better off putting any spare money into your pension where it has a chance to grow? In this article, we’ll find out.

Investing vs paying off debt

Before we get to tackling the big question, let’s look at the basic principle we’re dealing with - is it more financially effective to invest your money or pay off debt? The answer will be influenced by both the amount you expect your investments to grow and the amount of interest charged on that debt.

High interest debt

High interest debt typically includes personal loans and credit cards, where interest rates can be as high as 20% (or even more).

This kind of debt can be dangerous because small borrowing amounts can grow quickly without careful management.

There are few (if any) ways to invest your money to achieve a similar rate of growth, without risking losing your money altogether. So for this reason, it’s generally advised to pay off high interest debt before investing money elsewhere.

Low interest debt

Low interest debt is generally considered to include loans charging up to around 5% interest, although there’s no exact defined figure.

This kind of debt is considered relatively low-risk because there’s little chance of it quickly spiralling out of control.

In addition, you don’t have to risk everything to invest your money in ways that could outgrow low interest debt.

For example, the highest earning savings account is 3.5% at the time of writing. So putting your money into that account could be more financially effective than paying off a lower-interest loan of say 2%.

Plan 1 student loans

If you started university before 1st September 2012, you’ll likely have the Plan 1 student loan which charges 1.1% interest.

You’ll start repaying your loan if you earn £382 a week or £1,657 a month (before tax and other deductions).

Because the interest rate is very low, it shouldn’t be too difficult to find ways to invest any spare money to outpace the growth of your student loan.

For example:

  • Say your remaining student loan was £5,000 costing 1.1% interest
  • And you had £5,000 sitting in a savings account earning 3.5% interest
  • The interest on your student loan would cost £55 a year
  • But your savings would earn £175 a year

Leaving your money in your savings account would make you £120 better off at the end of the year, since that’s what you’d have left after paying the interest on your loan.

Plan 2 student loans

If you started university after 1st September 2012, you’ll likely have the Plan 2 student loan. As of September 2021 it charged between 1.5% and 4.5%, but this changes each year and is also dependent on your income.

You’ll start repaying your loan if you earn £524 a week or £2,274 a month (before tax and other deductions).

Because the interest rate is potentially as high as 4.5%, it would be more difficult to find relatively low-risk ways to invest any spare money to outpace the growth of your student loan.

For example:

  • Say your remaining student loan was £20,000 costing 4.5% interest
  • And you had £5,000 sitting in a savings account earning 3.5% interest
  • The interest on your student loan would cost £900 a year
  • And your savings would earn just £175 a year

At first glance, leaving your money in your savings account would leave you £725 worse off at the end of the year.

However, Plan 2 student loans get written off after 30 years if they haven’t already been paid. And with today’s students graduating with around £45,000 in student loan debt, it’s unlikely they’ll ever be paid off through regular payments, unless they earn a very large salary.

For the majority of graduates (those starting on salaries less than £40,000) it’s unlikely to be worth paying off their student loan early, and instead making the minimum payments until it’s eventually written off.

What if the repayment threshold changes?

In September 2021, the government was reportedly considering lowering the earnings threshold at which graduates start to repay their Plan 2 student loans from £27,295 to around £23,000. This could reduce graduates’ take-home pay by up to £800 a year and limit the amount they could put towards further loan repayments or their pension. However, regardless of this change, we think the considerations outlined in this article still apply to anyone considering whether it’s better to pay off their student loan early or top up their pension.

Investing in your pension

As we’ve seen, investing your money can sometimes be more effective than paying off some lower-interest debts. But in these examples we’ve focused on short periods of time. So what happens to investments over a period of 40 years or more?

Pensions are long-term investments. You can start one when you get your first job after university, and it can start paying you an income as soon as you choose to retire after the age of 55.

Unlike other investments, pensions have two particularly good features:

  • Your employer will contribute towards your pension (at least 5% of your salary)
  • The government will top up your personal contributions by 25%

So for every £1 you pay in, the government will add 25p. And that’s in addition to whatever your employee pays in.

So comparing paying off your student loan to investing in your pension is slightly different from other kinds of investments.

Let’s look at an example:

  • You’re 21 and decide to put a spare £500 into your pension
  • The government tops up your contribution by £125 (25%)
  • So a total of £625 goes into your pension
  • Your pension grows at an average rate of 5% until you retire at 67
  • Your initial £500 investment is now worth £4,963

Had you used that money to pay off part of your Plan 1 student loan, you’d have saved yourself £5.50 (1.1% interest). And you’d have lost out on a potential £4,463!

Of course, there’s no guarantee that the money you put into your pension would grow by this amount. But then it could grow even more. This is the risk you take when you make investments that can go up or down.

You’ll also need to consider that the earliest you can access your pension is from the age of 55. So you’ll need to be sure you won’t need to access that money sooner.

Is it better to pay off your student loan or top up your pension?

Graduates with a Plan 1 student loan are more likely to see a better return on their money if they invest in a pension. Graduates with a Plan 2 student loan will need to consider whether they intend on paying off their loan in full or pay the minimum until it’s written off after 30 years - if they do (this usually applies to higher earners) it could be more effective to pay off the student loan first, since the interest rate would be hard to beat with any low-risk investments.

All this said, it’s also worth noting that the emotional impact of living without debt can be liberating. However, before deciding to pay off your student loan for the sake of your mental health, it’s worth speaking with an independent financial adviser to help confirm whether doing so is really in your best interests.

Risk warning: As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.

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