If you’ve recently packed a child off to university, you’ll be hoping you’ve done all you can to prepare them — financially as well as emotionally.
The university experience in England comes with a hefty bill. The average undergraduate degree now costs £27,750, and that number can easily double when factoring in the cost of living. However, a comprehensive student loan system means that most decide to go ahead and pay for the pleasure over the course of their professional lives.
The loan carries a significant long-term cost. It accrues interest from the day funds are received in the account, and graduates will repay 9 per cent of everything they earn over £27,295. The interest rate used is based on the retail prices index on September 1 each year. There have been interventions to ease this burden, including an announcement in August that the interest rate on student loans will be capped at 6.3 per cent, instead of the 12 per cent figure implied by RPI inflation.
However, if parents are fortunate enough to have the funds available, they may want to avoid these added charges by paying the university tuition fees themselves. Only a few currently do: of more than 1mn students eligible for tuition fee loans in 2019-20, only 5 per cent did not take one up, according to government data.
As well as reducing the extra interest accumulated over the years of repaying a student loan, paying university fees directly through regular gifting out of surplus income would help reduce the value of a family’s estate, which may be effective for inheritance tax (IHT) purposes.
Paying the fee directly also beefs up the take-home income for a graduate once they start earning, which could be used for investment purposes. Graduates could also direct the money that otherwise would have gone to paying off a student loan into a personal pension, further solidifying their long-term financial future and allowing them to benefit from a generous tax uplift equal to their marginal income tax rate, at 20, 40 or 45 per cent in other words.
Avoiding the student loan system will benefit graduates when it comes to buying property. Mortgage affordability calculators factor in any student loans, so if a student still has a large amount to repay when they are ready to buy a home this may marginally reduce the amount they are able to borrow.
Families with the means and the interest to look at an investment-oriented alternative may look to a third option: take out the student loan to fund the costs, and invest the money parents would have spent on university fees to try and get the best returns. However, this is a high-risk strategy and not an approach I would recommend.
In a high-inflation environment, cash held on deposit rapidly loses its value in real terms. Normally this would present an investment opportunity, as investing the money provides the potential to generate above-inflation returns over the medium to longer term. However, in this case, the time horizon on investments is very short, since you will need to use the funds to generate a better return before any repayment is due.
Student loans become repayable as soon as the graduate starts earning an income, so potentially three years after they are received. The best current fixed term Isa account on the market over a three-year period is offering an interest rate of around 3.2 per cent. Comparing this with a student loan that potentially gathers interest at 6.3 per cent, the funds are therefore being eroded by 3.1 per cent a year in real terms.
To beat the current interest rate being charged, families would need to look at higher-risk investments, but I would counsel against this. In another climate the picture might be different, but in 2022 the investment options to support children through university are more limited and parents need to consider whether they are willing to gamble with their children’s future in an already volatile macroeconomic environment.
This brings us back to the student loan. It is well known and well understood, with many benefits in the short term. But the long-term interest and tax could add to the financial burdens on a young adult as they look to strike their own path through life.
If parents have the capital available, paying the fees directly can save significant costs in the long term. For those without it — and if you expect your child to become a middling-to-high earner — the best option is likely to be the student loan, with parents providing regular help after graduation to pay it off.
This method will allow families to reap potential IHT benefits and maximise the children’s future disposable income in a way that puts them firmly on the road to financial independence.
James Hymers is a wealth manager at Raymond James, Spinningfields