Understanding Student Loan Interest

Interest on student loans can be confusing, with different rules for each loan plan and circumstances. Understanding how interest is calculated is crucial for making informed decisions about your student loans.

This guide explains exactly how interest works across all UK student loan plans, how it accumulates, and why it might matter less than you think for many borrowers.

Most UK student loan interest rates are based on the Retail Price Index (RPI), a measure of inflation that tracks the changing cost of a representative sample of retail goods and services.

What is RPI?

RPI is one of several measures of inflation used in the UK. Unlike the Consumer Price Index (CPI), RPI includes housing costs like mortgage interest payments and council tax. RPI is typically higher than CPI by around 0.7-1% per year.

For student loans, the RPI figure from March is used to set interest rates starting from the following September. For example, the March 2023 RPI figure (around 2.6%) was used to set student loan interest rates from September 2023 to August 2024.

Why Does RPI Matter?

RPI forms the basis for all student loan interest calculations:

• For Plan 1, interest is the lower of RPI or the Bank of England base rate plus 1%
• For Plan 2, interest ranges from RPI to RPI + 3% depending on income
• For Plan 5, interest is fixed at RPI only
• For Postgraduate loans, interest is fixed at RPI + 3%

When RPI increases, student loan interest rates increase as well, meaning your loan will grow faster if you're not making repayments that cover at least the interest.

Plan 1 Interest Rates

Plan 1 has the simplest interest structure of all student loan plans:

This approach provides a form of interest cap for Plan 1 borrowers. For example, when RPI was high at 11.9% in March 2022, Plan 1 borrowers still paid just 4.5% interest (bank rate + 1% at that time), which was significantly lower.

The Plan 1 interest rate applies regardless of your income or whether you're studying or have graduated.

Plan 2 Interest Rates

Plan 2 has the most complex interest structure, with rates that vary based on your circumstances and income:

The sliding scale for middle-income earners is calculated proportionally based on where your income falls in the range. For example, if you earn exactly halfway between the lower and upper thresholds, your interest rate will be RPI + 1.5% (halfway between RPI and RPI + 3%).

Plan 5 Interest Rates

Plan 5, introduced for students starting university from September 2023, has a simplified interest structure:

Unlike Plan 2, the interest rate for Plan 5 does not vary based on your income or whether you're studying or have graduated. This makes it easier to understand and predict growth in your loan balance.

This lower interest rate is one of the benefits of Plan 5 compared to Plan 2, particularly for higher earners or those with large loan balances, though it comes with other trade-offs like a lower repayment threshold and longer repayment period.

Postgraduate Loan Interest Rates

Postgraduate loans (for Master's and PhD study) have a fixed interest structure:

This rate applies from the day the first payment is made to you until the loan is fully repaid or written off. It does not vary based on income.

During periods of high inflation, there can be substantial gaps between student loan interest rates and prevailing market interest rates. To address this, the government may apply caps on student loan interest.

The Prevailing Market Rate Cap

By law, student loan interest cannot exceed the "prevailing market rate" for comparable unsecured personal loans. This is designed to prevent student loan interest from becoming excessively high during periods of high inflation.

For example, when RPI reached 11.9% in March 2022, this would have meant Plan 2 and Postgraduate loan interest rates of 14.9% (11.9% + 3%). The government instead applied a cap, reducing the maximum interest rate to around 7.3%.

These caps are applied automatically when necessary and do not require any action from borrowers.

A common misconception is that interest only begins after graduation. In reality, interest starts accruing on your student loan from the moment the first payment is made to you.

Interest During Study

For all plan types, interest begins accumulating at the relevant rate as soon as the Student Loans Company makes the first payment to you or your university. This applies to both tuition fee loans and maintenance loans.

For Plan 2 loans, this means interest accrues at RPI + 3% throughout your entire study period, potentially adding thousands of pounds to your loan balance before you even graduate.

While this initial interest can seem alarming, remember that it only impacts you financially if you're likely to repay your loan in full before the write-off period.

Student loan interest is calculated daily and added to your balance monthly. This means compound interest applies – you'll pay interest on your interest.

The Calculation Process

1. Your annual interest rate is divided by 365 to give a daily rate
2. This daily rate is applied to your outstanding balance each day
3. At the end of each month, the interest is added to your balance
4. The next month's interest is calculated on this new, higher balance

Income-Based Rate Changes

For Plan 2 loans, where the interest rate varies by income, the SLC reassesses your interest rate at the end of each tax year based on your actual earnings. During the tax year, they use an estimated interest rate, which may be adjusted retroactively once your actual earnings are known.

One of the most important aspects of student loan interest to understand is that for many borrowers, especially those with Plan 2 or Plan 5 loans, the interest rate has no impact on how much they'll actually repay.

Why Interest Often Doesn't Affect Total Repayments

You only repay based on your income (9% above threshold), not your balance. If you won't repay your loan in full before it's written off, the interest rate is largely irrelevant to your total repayment amount.

In this example, the interest rate could be 0% or 10% – it wouldn't change how much the borrower actually repays, because their repayments are determined solely by their income.

When Interest Rates Do Matter

Interest rates become important in the following scenarios:

• High earners who will repay their loan in full before the write-off period
• Borrowers considering voluntary extra payments to reduce their loan
• Those concerned about the psychological impact of seeing a large loan balance
• When applying for mortgages or other loans where affordability assessments might consider your student loan balance