Sunday, May 29, 2011

HECS HELP Student Loan: Lump sum payment

Goodbye $3,500 .... I made a lump sum payment against my student loan last Friday. I was reluctant to part with it because it meant that the $3500 won't be sitting in my account accruing interest income for me at $17.06 per month. 

So you're thinking "Bah $17.06, that's nothing!" Let me show you the ramifications of that $17.06/month passive interest income that has been forgone.

Although $17.06/month pre-tax isn't truly significant, the after tax amount could have bought me each month(until I reach 65 yo)**:

* Two sandwiches at the sandwich bar (840 sandwiches) OR
* 28 super soft, freshly baked bread rolls that I love munching on (11,760 bread rolls) OR
* 3 kilos of apples (1,260 kg of apples) OR
* 4 kilos of oranges (1,680kg of oranges) OR
* 2 litres of vanilla ice cream (that's 840 litres of ice cream)  OR
* 4 vanilla slices (that's 1,680 vanilla slices!)

It could have been a passive income of $17.06/month, EVERY month, EVERY year for the rest of my life. Is that starting to sound more significant yet?

$17.06/month in interest income is:
$204.72/year and
$23,389 in total across the next 35-40 years until retirement age**

So maybe I've convinced you to agree that missing out on $23,389 of forgone, sacrificed income does sound significant. It's more significant when you realise that it would have been $23,389 for doing zilch, absolutely nothing at all. All I had to do was let it accumulate and compound every single year until I reach 65yo (if I survive to that age).

You can acquire those benefits too

By saving $17.06 more each month OR by spending $17.06 less each month. All those actions will translate roughly into $23,389 when you're 65yo, presuming you're in your twenties to early thirties.

So why did I make a lump sum payment?

Unfortunately the Government cut the discount rate for upfront lump sum payments of $500 and more from 10% down to only 5%. HECS/HELP loan indexation occurs on 1st of June every year. So by paying $3500, my loan will decrease by $3,850 and also I don't get indexed on $3,850 potentially saving me $115.50 (assuming the inflation indexation rate is 3%). That means a total of $3,965.50 off my loan balance from paying just $3,500.


* Those are pre-tax numbers and will obviously be less with tax
* Assuming I save that $17.06 every month for the next 35-40 years
* That $1 today isn't more valuable than $1 in the future (when $1 today is worth more than a future $1 due to inflation)
* That the compounding interest rate is 5.85% return per annum (what my savings are currently earning)
* That you've got 35-40 years before you turn 65yo
* Assuming prices of apples, ice cream and vanilla slices are the same in 35-40 years (which it won't be because there's always going to be inflation)

Further reading:
1. Perform monthly or fortnightly financial health checks for optimum results
2. Understanding loans and their features

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