Should you pay off your HECS or invest under new proposed policies?
With the cost of education increasing and federal re-election campaigns fired up, find out what new changes to HECS may mean for investors.
This is the second part of my two-part series on the Albanese Government’s proposed new initiatives to HECS and whether investors should pay down the debt or invest.
What the changes could mean for you
Firstly, it is important to establish that this conversation and these policy changes depend on the re-election of the Labor Party next year.
The lower annual repayment amounts being proposed directly affect the level of disposable income debtors have and how long it takes to repay the debt. Under the new proposal, most debtor groups end up repaying less, increasing their annual disposable income but extending the repayment period and overall indexation for lower income groups (should they not make any voluntary contributions).
Cost of living pressures effect everyone to some extent. However, the higher end of income earners may not have the same immediate need for the extra disposable income. The question here is whether to redirect the cash towards voluntary contributions to continue paying HECS debt, or to invest and hope to make a return higher than the predicted rate of indexation.
HECS is largely referred to as ‘good debt’, a term that refers to debt that is used to achieve meaningful growth in an individual’s personal life or finances. The debt doesn’t accrue interest, however, does change in line with inflation. Theoretically this makes it one of the cheapest forms of debt you could have in comparison to a mortgage or credit cards. Despite last year’s 7.1% indexation, historically it has remained below 2%, compared to average fixed mortgage interest rate of ~6.5%.
The disposable income the new proposal provides can either be invested, put in a mortgage offset account or used to pay off other debt with higher levels of interest. From a cash flow perspective, paying off a debt with an indexation of 2% makes little sense when the same principal could be invested in the market with 6 – 8% returns – covering not only the impact of indexation but also garnering returns. One must also take into consideration the effect of capital gains tax and whether returns after taxation are still higher than indexation.
In a study done by the Federal Reserve Bank of Richmond, research found that differences in earnings across workers are large and become larger as workers age. The study also categorised this data into ‘richer’ and ‘poorer’ subgroups, finding that the ‘richer’ group experienced steady wage growth whilst the wages of the median worker do not grow as much. For the purpose of this example, we take the median as a representation of the overall larger population.
Below is a graph that outlines average real wage by age, indicating wage growth tends to be higher for individuals earlier in their career, then eventually slows as the years pass.
Figure 2: Average Real Wage by Age.
What this indicates for the average person is that your initial few years of wages are growing at the highest rate they will over your lifespan, therefore it is crucial that the money you make in this period is allocated efficiently.
I ran a few calculations to determine the real impact of the new policy proposals on an individual's cumulative indexation accrual and changes to the time taken to repay the balance.
Here are my assumptions: the individual earns $110,000 for the first 3 years of their career then gets a salary increase to $120,000 which holds for the remaining period. Indexation has been assumed at 2.6% by taking an average of the last 10 years indexation rate (not including recent credit adjustments).
Figure 3: HECS pay down over time. Source: Author calculations.
For a middle-income earner, the new proposal decreases overall indexation accrual by $1,215 whilst there is no major difference in the period it takes to pay down the total debt.
In this case, the individual has $700 annual disposable income for the first three years of the payback period, and $450 for the remaining for years. If you invest the extra disposable income annually in the market, over the life of the loan at a 7% rate of return, the future value would be ~$4470 which surpasses the accrued indexation of $3,9557.
Other considerations
Like many of us, the liquidity of funds also remains a concern. If an individual dies with outstanding HECS debt, the balance gets written off. Therefore, those with disposable income would benefit more from directing cash to an offset account or the investing in the market where it can be accessed by dependents if necessary. There is an opportunity cost to paying down the debt now or spending the money elsewhere in anticipation of a proposal that hasn’t been ratified.
At the risk of sounding bias, the conclusion to be drawn here isn’t to entirely avoid paying down your HECS. It largely depends on the individual’s circumstances. For example, outstanding HECS can also affect a home loan application in the lender’s affordability assessment and changes the debt-to-income ratio which impacts your borrowing power.
Individuals with smaller debt balances and higher incomes have the ability to make voluntary repayments. Of course, this goes against most financial advice. However, if it can be achieved without significantly impacting your cash flow, the psychological achievement of being debt free is unquantifiable.
I think one of the largest misconceptions about personal finance is that it only champions strategy, efficiency and maximisation of returns. Of course, these could all hold true, but rationality and mathematics shouldn’t be the only thing to inform financial decisions. If your personal goal is to pay off your HECS debt and you are in a cash flow position to do so, it is worth considering how important the weight of your own goals are, along with general financial advice.
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