Another broken rung on the property ladder

Ladders

I helped out Independent on Sunday recently with its Wealth Check about Rove Mejia – an employee with a student loan – saving up to buy a property.

The case study made me think about the impact of debt on our young professionals.

Borrowing the maximum for a three year course produces a debt just of £50,025.  The repayments are £74.58 per month in this example (Rove earns £28,000).  That doesn’t sound too bad, but those payments are predicted to last well over sixteen years.  This affects how much graduates can borrow, for a long time, in two ways.

1 – Debts reduce mortgage capacity

You may be aware that when you take out a mortgage, any ‘ongoing’ financial commitments are deducted from your income.  In our example, the repayments go up over time, from £895 to £7,672 per year.  Repayments also go up when you get a pay rise above inflation, capped at £35,000.

It’s not surprising that mortgage lenders need to take that into account – it would hardly be ‘responsible lending’ to disregard that debt.  Fundamentally, the student loan repayment is an effective pay cut of at least the starting repayments.

It’s not quite a ‘blank cheque’ because the payment is capped at almost 4.9% of gross income.  That’s really 6.5% after tax.  In short, a long-term liability.

2 – Inflation doesn’t help here

Normally, if I take on a sixteen year loan, I don’t need to worry about the future costs, because I expect my earnings to rise with inflation.  Over time, I expect my income to rise so that £74.58 repayments take up an ever smaller share of my pay.

But.  My Student Loan Company interest rate is set at the lower of the Retail Prices Index or 1% above the Bank of England base rate.  This means that my payments will increase when inflation increases because the cost of repaying the loan is linked to inflation.

In short, a long-term real liability. Even more worrying, for imminent graduates, is the realisation that a sustained period of fairly high inflation would help get rid of our budget deficit.

For me, this proves that debt is never healthy for good financial planning.  I have heard the argument that it’s worth taking the student loan because the rate is so low.  I’ve never been in favour of this.  This real-life example demonstrates some of the hidden pitfalls.