Let's Look Logically At Paying Hecs Upfront: Don't Be A Mug

The Age

Saturday March 13, 2004

ROSS GITTINS

This is the time of year when many uni students and their parents demonstrate their ignorance of a key concept in economics and business: the ``time value of money". When it's used in business and finance to evaluate investment proposals, as it is every day, it's more commonly referred to as ``discounted cash flow" analysis, which yields a bottom line called the NPV net present value. If you've ever come across these terms and been puzzled, keep reading.

Knowing about such arcane stuff is the key to jumping the right way when you decide whether to pay your HECS fees upfront and get the 25 per cent discount or to have the taxman take the repayments out of your pay after you get a job.

Many conclude you'd be a mug not to take the discount if you had the money. But get this: it's not at all obvious the 25 per cent discount is a good deal. Most students will end up richer if they let their HECS debt pile up. How could that be? Because of the ``time value of money".

Economists believe that, when it comes to paying or receiving money, it's not just how much that matters but when it happens: a dollar today is worth more than a dollar tomorrow (or in a year). The proposition would hold true with no inflation. Why? Because humans are impatient animals. If we had the dollar today, we could spend it today, which would be better than having to wait. (Or it could earn interest in a bank.)

I could express your degree of impatience as your personal ``discount rate". If your discount rate was 6 per cent a year, the promise of receiving a dollar in a year's time would be worth 94.3 to you today. That 94.3 is said to be the ``present value" of a dollar in a year's time, at a discount rate of 6 per cent. Note that this calculation works both ways. If you're going to be paid a dollar in a year's time, its value to you today is only 94.3 . But if you have to pay the dollar in a year, its cost to you today is only 94.3 . If today you put that 94.3 into a bank paying 6 per cent, in a year you'd have the dollar needed to pay your debt. (So discounting is compound interest in reverse.)

Most business investments take the form of shelling out a lot of money now in the hope of receiving back a small stream over many years. Those distant-future dollars aren't worth nearly as much as the ones you'll have to cough up right now. So the distant dollars need to be discounted before they're set against the present dollars to give the investment project's ``net present value".

If you're highly aware of the need to discount future events, you view the HECS arrangement as remarkably generous. Students owe the government money, but it allows them to delay repaying until they can afford to. A bank would charge you interest, but all the government does is adjust the amount in line with inflation. In other words, it charges you a real interest rate of zero. A ``rational" person would need a lot of persuading to pay off such a loan before they were obliged to.

So the key question: is a 25 per cent discount big enough to outweigh the attraction of a loan with no real interest rate? Let's say the HECS amount this year is $4000. With a 25 per cent discount you'd pay $3000 upfront. You compare that with the present value of all the repayments you'd have to make over the years after you graduate.

If the present value exceeds $3000, pay upfront and the difference (not the $1000 discount) is what you save. If present value is less than $3000, it's not worth your while. That's the theory. In practice, working out the present value of the stream of future debt repayments is a job for an expert with a computer program. And you have to guess how much you'll be earning (because that's how the size of your repayments is determined).

But don't forget: HECS rules are about to change. Students who started their courses before next year won't be affected by the 25 per cent fee rise. But from this July, the income threshold at which you have to start repaying jumps from $25,348 a year to $35,000 (and to $36,184 from July next year). And from next January the upfront discount drops from 25 per cent to 20 per cent.

It's obvious this cut in discount makes paying upfront less attractive. But so, too, does the jump in the income threshold. It tends to push repayments further into the future, meaning they're more heavily discounted to reduce them to their present value. And the lower the present value, the less likely that paying upfront will yield genuine savings - except perhaps for those whose earnings in their first 10 or 15 years as a graduate are significantly above the average for graduates.

© 2004 The Age

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