July 23, 2024

Higher long-term interest rates and the cost of student loans

4. How does this compare with official statistics?

Official public finance statistics take a different approach to accounting for the cost of student loans, developed by the Office for National Statistics (ONS). Under this approach, only the share of loans that is not expected to be repaid with interest counts as government spending when loans are issued. Any interest charged on the share expected to be repaid is counted as a receipt in the year in which it is added to the loan balance (actual repayments do not count as receipts).
 Any interest on government borrowing to fund these loans is counted as part of general interest spending, which is a separate spending category in the public finances. 

This means that in addition to a spending item when loans are issued reflecting the part of loans that is not expected to be repaid, student loans spending under this approach generally also generates future receipts (interest on the share of student loans expected to be repaid) and future spending (government interest spending). If the student loan interest rate was equal to the government’s cost of borrowing, future interest rate spending on government borrowing to finance the part of student loans expected to be paid back would be just offset by future receipts from interest charged on student loans. 

In reality, interest rates on loans can differ from the government’s cost of borrowing. Due to the rise in the government borrowing costs over the past two years, we have gone from a situation where the government could expect future receipts from student loan interest to exceed borrowing costs to finance the part of student loans that is expected to be paid back, to one where borrowing costs are expected be substantially higher than receipts from student loan interest. None of this change is reflected in the public finances at the point when loans are issued, as the share of loans that will be paid off only depends on the interest rate charged on student loans and not on the government’s cost of borrowing.

A different accounting system is used by the Department for Education (DfE) to calculate the so-called ‘RAB charge’, which – somewhat inaccurately – is commonly cited in policy discussions as a measure of the share of student loans that is not expected to be repaid. To calculate the RAB charge, student loan repayments are discounted at the ‘real financial instrument discount rate’ promulgated by the Treasury. The calculation proceeds in two steps. First, a nominal discount rate is calculated as the backward-looking 10-year rolling average of average-time-to-maturity (roughly 15-year) gilt yields. Then, a prediction for RPI is used to produce a rate relative to RPI inflation.

While the financial instrument discount rate is thus tied to gilt yields, it largely reflects historical rather than current yields. As gilt yields have increased rapidly over the last two years after a long period of exceptionally low yields, the financial instrument discount rate is now nowhere close to the government’s cost of borrowing. The RAB charge therefore does not reflect actual borrowing costs at the moment, and likely will not for several years to come. In fact, because RPI forecasts are not averaged over 10 years in the same way as nominal gilt yields, the most recent revision of the real financial instrument discount rate has paradoxically been downwards due to higher expected inflation, even though actual expected government borrowing costs have risen substantially in real terms.

All this means that official statistics are likely understating the true cost of the student loans system. The ONS measure focuses only on the share of loans that is not repaid in full and thus misses the spread between government borrowing costs and student loan interest rates, which is now expected to be negative. The RAB charge method fails to account adequately for recent changes in borrowing costs due to the backward-looking approach to choosing the discount rate.

Table 1 summarises how the estimated long-run costs of providing student loans to the 2023 cohort vary under different methodologies. Method 1 shows the estimated cost if future repayments are discounted at the market yield on 15-year gilts from December 2021. This gives a cost of minus £3.2 billion, as described in Section 3. Method 2 repeats the exercise but uses up-to-date 15-year gilt yields. This suggests a cost of £7.3 billion – more than £10 billion higher. Methods 3 and 4 show the substantially lower cost implied by the ONS (£2.6 billion) and RAB charge (£0.4 billion) measures, respectively. 

Table 1. Long-run costs of funding undergraduate student loans for the 2023 university entry cohort, different methodologies

Method Nominal discount rate Expressed in terms of (expected) RPI inflation Long-run cost of student loans 
(IFS model)
1. Discounted using yield on 15-year gilts, end of 2021 1.2% RPI – 1.4% –£3.2bn
2. Discounted using yield on 15-year gilts, end of 2023 4.0% RPI + 1.6% £7.3bn
3. ONS write-off share RPI RPI £2.6bn
4. RAB charge cost measure (latest) 1.9% RPI – 1.3% (pre-reform)
RPI – 0.2% (post-reform)

Source: Yield data from Bank of England, as of 2 January 2024; IFS student finance calculator.

However, it is worth noting that modelling the cost of student loans generally relies on strong assumptions, and DfE’s own model has long been more pessimistic about graduate earnings and thus student loan repayments than our model. As a consequence, even if we apply a discount rate reflecting the current 15-year gilt yield, our estimate for the long-run cost of student loans for the 2023 entry cohort is only slightly higher than costs implied by official forecasts.

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