Repay your loan as slowly as possible

16:00, Apr 02 2013
student debt
BREATHE EASY: If you're a borrower living in New Zealand, the best course of action now is to kick back and let the taxman drag your loan back from your paycheque, cent by measly cent.

Monday was a day of new beginnings. We celebrated the good lord's rise from the grave with a three-day chocolate and hot-cross-bun binge.

In less joyous news, a new tax year began, and with it came a series of changes to the student loan scheme.

Monday marked the closure of a 10 per cent bonus for voluntary repayments made to your loan balance.
The minimum repayment was also raised from 10 cents to 12c in every dollar earned above the $19,000 threshold.

With these changes now in place, it's time to reassess the smartest method for casting off your student debt millstone.

So what should you do?

Nothing at all.

That's it. You can breathe easy. If you're a borrower living in New Zealand, the best course of action now is to kick back and let the taxman drag your loan back from your paycheque, cent by measly cent.

The last incentive for making an early repayment has officially gone down the gurgler.

From here on in, it makes sense to repay your loan as slowly as possible. Here's why.

Inflation is your friend

A $5 note will buy you a lot more right now then it would 10 years down the track.

The Reserve Bank aims to keep inflation running between 1 and 3 per cent, and historical data shows it's averaged about 2.7 per cent since 2000.

In almost every situation, inflation is your enemy. Each year, it steadily eats away at the true value of the cash in your bank account. 

It chips away at your debts too, but that's negated by the interest that you have to pay.

Student loans are unique, in that they are interest-free for borrowers living in New Zealand.

What this means is that each year, the outstanding balance of your debt shrinks by about 2.7 per cent in "real" terms.

You can use inflation to deliberately eat away at the value of your loan, and turn your spare cash towards much more productive activities.

Let's say you have a loan of $30,000, and have managed to accumulate the cash to pay it off immediately.

You could pay that back and be debt-free. But 10 years down the track, the same-sized debt would have dwindled to just $24,000 in real terms.

Of course, you'll be making compulsory repayments along the way. But each year, whatever remains is eroded by an extra few per cent.

Gaming the system

The early repayment bonus was scrapped because people were exploiting it.

"We weren't getting the benefits of advanced payments because of the way it was working," says Revenue Minister and United Future leader Peter Dunne.

"What, in fact, we saw happening was that people were reclaiming the repayment bonus in the last years of their repayment."

There are plenty of boffins-in-training in the finance department at University of Auckland who had it all figured out.

One mathematics major - who asked to remain anonymous- has been borrowing as much as possible throughout his study.

"I'm in my fifth year, so that's five years of compound interest, which is not to be laughed at," he says.

Last week he managed to scrape together almost $20,000 to take advantage of the voluntary repayment bonus before it closed.

"I worked a lot over summer. I borrowed as much money as I could - from family, from wherever - because you can't beat a 10 per cent interest rate."

Now he's back to borrowing more and building up the interest again. From here on in, he'll repay the loan as slowly as he can while inflation eats away the balance and he earns money on his investments.

Psychological vs Financial

So far we've only been considering a purely financial point of view.

Infometrics economist Benje Patterson points out that psychological factors come into play for some people.

"For whatever reason, it makes them feel bad to have it hanging over their head even though its more rational from a financial perspective to actually drag it out."

He also points out there are three situations where it could make sense to get your loan off your back as fast as possible:

1. If you live overseas, and are therefore accumulating interest.

2. If you intend to travel overseas in the near future, and as such will incur interest.

3. If you're worried that the Government will reintroduce interest to loans.

Some people in the latter camp might prefer to pay their loan off quick sharp to avoid any risk of getting pinged with interest again.

But Patterson doesn't expect a u-turn on the interest-free student loan policy from the powers-that-be.

"The Government has ruled it out this term, and I can't see them going the full hog and reintroducing it any time soon."

Dunne confirms that the Government has no intentions in that regard. "It probably is politically a no-go area," he says.

In any case, the best course of action is to put any spare money aside and save it up. That way if the unlikely ever does happen, you can repay your loan instantly.

Even with the higher repayment rates that kicked in on Monday, someone earning the average salary of $42,000 is still only compelled to pay back about $2750 a year. 

That should hopefully leave some slush for saving and investing a little on top.

Moral quagmire

Lastly, a question of ethics.

We've ignored any moral arguments up to this point, because this is all about improving your own personal finances.

That's where the problems begin.

"What's rational for an individual conflicts with what's rational for society," says Patterson. 

"I would desperately want some sort of mechanism to stop me exploiting it - but it's not there, so I'll exploit it anyway because I don't want to see other people making a buck that I can't."

Patterson is literally asking the Government to "tie my hands behind my back" so that he and others cannot exploit the distorted system.

But the Revenue Minister isn't too worried about local debtors dragging their feet anyway.

"In many senses, domestic borrowers aren't our problem," says Dunne.

They repay their loans relatively quickly, a process which will become even faster at the higher repayment rate. 

"Our problem is with our overseas based borrowers, who have an attitude on the whole that once they've left New Zealand they've left their responsibilities behind," says Dunne.

He thinks it's wrong that many people offshore are "giving the proverbial two fingers to the system" while local borrowers are working hard to pay their dues.

Naturally, the taxman is starting to crack down on loan-dodgers overseas.

So as long as you meet the required repayments, you shouldn't feel too bad.

Whether it be through shrewd calculation or sheer apathy, you can guarantee that almost everyone else is doing the bare minimum too.