Should You Repay Your HECS Early?

Did you know the ATO offers a 5% discount on voluntary HECS payments above $500?

It’s a pretty sweet deal, but doesn’t stack up in every scenario. So to help you make a financially informed decision, let’s weigh up getting the discount against investing that money yourself.

HECS Basics

HECS is a debt which the ATO charges you interest on – also known as indexation – at around 2.5 per cent per annum. If you have a $35,000 HECS debt this year, it will grow to $35,875 next year.

The Do Nothing Case

Suppose Pete has diligently saved up $20K in a high interest saver account, earning 3.7 per cent (slightly higher than the current indexation rate).

Over the next 5 years, Pete will make $740 to $820 of interest each year, and will have to pay around $250 tax on that interest. This will leave him with $500 to $550 after tax.

The total value of his interest after tax for the 5 years is $2,625.

Based on Pete’s salary, it will take him 5 years to repay his HECS under mandatory repayment. His personal tax rate is 32.5%.

The Early Repayment Scenario

If Pete pays off his HECS early with his $20K, the ATO will wipe off $21K from his HECS after the 5% discount. It’s like getting $1,000 for free.

If left unpaid, the $21K debt would have accumulated $2,760 of interest (at 2.5% indexation) over the next 5 years. So the total savings from repaying early is $3,760 over 5 years.

pay hecs early chart 1

Clearly, under these assumptions, Pete should pay the HECS debt early as he would be $1,651 better off over 5 years.

A Different Investment Approach

This story would be different if Pete was interested in investing in something more risky, like the sharemarket.

In the last 10 years, the sharemarket generated an average annual return of 9.2 per cent, per year. Beware though, the past can’t predict future returns, and the market could also lose money in the next 5 years.

However, over the longer term, say more than 7 years, it should provide returns around that average.

If the market did provide 9.2 per cent each year to Pete, he would make $1,200 to $1,600 per year after tax for the next 5 years. Pete might even save on tax because of the Capital Gains Tax discount applied on shares held for over 12 months.

Over 5 years, Pete would come out $3,271 ahead by investing his money.

pay hecs early chart 2

 

Tick Tock, Tick Tock

Time is also important. The sooner you repay your HECS in full (via mandatory repayment), the more compelling it is to pay early.

If Pete was in a position to repay his HECS in 1 year under mandatory repayment, even investing in the stockmarket wouldn’t make sense.

One year earning that 9.2 per cent return would provide Pete with $1,242 after tax, compared to $1,525 savings by paying early.

What does it all mean?

The chart below summaries the situation. It’s worth investing your money when:

  • there is a long time until HECS is paid back in full;
  • you are willing to take risks with your investments

pay hecs early chart 3

Now, this is purely from a 100% financial perspective. There is nothing wrong with enjoying life in your 20s. Spending that money to travel the world, realising YOLO and the rest of it.

But it’s also a good idea to start a savings and investments strategies now. You don’t want to have fun only in your 20s. Having an investment plan will help you afford an exciting life in your 30s, 40s, 50s, even 60s and beyond.

How to pay early?

If you want the discount, you may need to act fast. The government is proposing to terminate the 5% discount starting from 1 Jan 2016. Find out how to pay early here.

Sources: Russel and ASX, 2014 Long-term Investing Report