The 6.1 per cent interest rate on student loans attracts outrage. Justifiably so – with a 0.5 per cent Bank of England base rate, charging students 6.1 per cent is scandalous.
But the 6.1 per cent rate is just the tip of the iceberg. For not only are students charged this, but the rate is compounded monthly – a mechanism that results in interest costs starting at £5.17 a day for borrowers of tuition fee loans only and £12.20 a day for borrowers with tuition fee and maintenance loans, starting on the 6 April in the year following graduation.
So less well-off students will not only graduate with double the debt of their wealthier peers thanks to the abolition of maintenance grants, but will also have to pay more than double the interest costs because they have to use maintenance loans.
The cost iniquity worsens: compound interest multiplies living costs for the less well-off as they cover their living expenses with an expensive maintenance loan. A £55 shop in freshers' week actually costs student borrowers more like £140 if repaid 15 years later.
Compound interest is different from what many call “normal” interest. Let us take a 30-year loan of £65,000 (roughly three years tuition fees and maintenance loans). Someone paying 6.1 per cent “normal” interest on £65,000 would pay £3,965 annually, a total of £118,950 for 30 years.
But when interest is compounded monthly, the interest is added to the original loan amount every month, thereby increasing the loan size. Monthly interest costs are calculated on the loan plus all previous interest added to it. Each month, the loan gets bigger and interest costs go up: in month one, £65,000 accrues interest of £330, which is added to the loan, increasing it to £65,330. At the end of month two, interest is calculated referencing the larger loan of £65,330 and costs £332 and so on.
After three months, the £65,000 loan is nearly £1,000 larger. Over 30 years, the £65,000 loan grows to £403,329; interest costs are a staggering £338,329. Compound interest is a genius mechanism for lenders.
This £65,000 example demonstrates how monthly compound interest wreaks havoc on student borrowers while rewarding the government lender. In "real life" these figures will differ because borrowers may pay off part (or all) of their loans and the rate of interest charged is variable until borrowers earn £41,000 (set to change to £45,000 in April 2018, subject to parliamentary approval).
It is clear that interest rates go against Lord Dearing’s equitable intention for the student finance system.
“Real interest rates can, however, have the effect of increasing the burden for those on lower incomes,” said the highly respected civil servant, whose 1997 report led to the creation of tuition fees. “With a zero real interest rate, by contrast, the highest subsidies go to those on the lowest incomes,” he added.
The 6.1 per cent monthly compound interest rate looks like an abuse of the equitable principles that Dearing and others set out; principles upon which the present system is, ironically, predicated.
There is now political resistance to reducing interest costs on student loans; however, cutting this rate would only benefit wealthiest graduates who would simply pay off their loans quicker, some argue. This is a shamefully specious argument because were it not for compounding interest mushrooming the size of student loans, any such advantages would be greatly evened out.
As Dearing said, a zero interest rate would benefit the less well-off more because they take longer to repay.
Worse, this defence ignores the elephants in the room: the cost and impact of the mental health problems triggered by out-of-control debts; the limits on lifestyle and drag on spending in the economy as graduate borrowers attempt to repay extortionate loan costs, often when they have families to support.
Huge debt is impacting the lives of less well-off students long beyond graduation both psychologically and practically, including having smaller mortgages. Compound interest creates a debt trap, which costs all taxpayers – not least those picking up the bill for the mental health crisis caused.
Put simply, this is a question of morality: it is immoral to charge children just out of school a 6.1 per cent compounded rate. An outrage, indeed.
Estelle Clarke is a former City lawyer and an advocate of fair terms for student loans. She is a member of the advisory board of the Intergenerational Foundation charity and tweets at @legalimportant. Her personal website is www.bouncingback.online/.