financing a loan

Time takes its toll on value of HECS discount

By Ross Gittins
March 13, 2004

This is the time of year when a lot of uni students and their parents demonstrate their ignorance of a key concept in economics and business – the “time value of money”.

Actually, 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 by them, keep reading.

But why would uni students and their parents benefit from knowing about such arcane stuff? Because it’s the key to jumping the right way when you decide whether to pay your HECS (higher education contribution scheme) fees in advance – and get the 25 per cent upfront discount – or let them ride and have the taxman take the repayments out of your pay after you graduate and get a job.

A lot of people take one look at that whopping 25 per cent discount and conclude it’s a no-brainer. If you had the money, you’d be a mug not to take advantage of the discount.

But get this: it’s not at all obvious that the 25 per cent discount is a good deal, and for most students it won’t be. They’ll end up richer if they let their HECS debt pile up.

How could that possibly 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 also when it happens. The basic proposition is that a dollar today is worth more than a dollar tomorrow (or in a year’s time).

Why? Not just because of inflation. The proposition would still be true if there were no inflation. No, the real reason is 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 we could put the dollar in the bank and earn interest.)

If I could quantify your degree of impatience, I could express it as your personal “discount rate”. And if, for example, your discount rate was 6 per cent a year, this would mean that the promise of receiving a dollar in a year’s time would be worth 94.3c to you today.

That 94.3c 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 94.3c.

But if you have to pay the dollar in a year’s time, its cost to you today is only 94.3c. If today you were to put that 94.3c into a bank account paying 6 per cent interest, in a year’s time you’d have the dollar needed to pay your debt. (So discounting is compound interest in reverse.)

Most business investments take the form of having to shell out a lot of money now in the hope of getting back a small stream of money over many years into the future. Those distant-future dollars aren’t worth nearly as much as the ones you’ll have to cough up right now.

So, to put all the dollars in the sum on a comparable basis, the distant dollars need to be discounted before they’re set against the present dollars to give the investment project’s “net present value”.

Now, if you’re a financial type who is highly conscious 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.

Normally, a bank would charge you interest on such a deal, but all the Government does is adjust the amount of your HECS debt in line with inflation. In other words, it charges you a real interest rate of zero.

What? Someone’s offering to lend you money at a zero real interest rate? A “rational” person would need a lot of persuading to pay off such a loan before they were obliged to.

The only thing that could induce them to do so would be a really huge discount for repaying upfront. So the key question is: is 25 per cent big enough to outweigh the attraction of a loan with no real interest rate?

Let’s say the amount of HECS involved this year is $4000. With a 25 per cent discount you’d make an upfront payment of $3000. You compare that figure with the present value of all the repayments you’d have to make over the years after you graduate.

If that present value is greater than $3000, make the upfront payment – and the difference (not the $1000 discount) is how much you save. But if the present value is less than $3000, you’d be a mug to pay upfront (assuming you’ve got the money). At a discount of only 25 per cent, it’s just not worth your while.

That’s the theory of it. In practice, however, 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 income you’ll be earning (because that’s how the size of your repayments is determined).

Don’t forget, however, that the HECS rules are about to change. Students who’ve started their courses before next year won’t be affected by the 25 per cent increase in fees (a fact the vociferous opponents of the changes haven’t bothered to stress).

But from July this year, the income threshold at which you have to start making repayments jumps from $25,348 a year to $35,000 (and goes to $36,184 from July next year). And from January next year, the upfront discount drops from 25 per cent to 20 per cent.

It’s obvious that this cut in the upfront discount makes paying upfront less attractive. But, for many students, so too does the jump in the repayment threshold.

Why? Because it tends to push repayments further off into the future, meaning they’re more heavily discounted to reduce them to their present value. And the lower the present value, the less the likelihood that paying upfront will yield genuine savings.

From what I can gather, it’s only those students whose earnings in their first 10 or 15 years as a graduate are significantly above the average for graduates who are likely to be better off paying upfront.

From: http://www.smh.com.au/articles/2004/03/12/1078594564502.html

Gilad,

Although I don’t exactly know your situation, one way may be to access your parents equity in their home. Firstly to get the deposit, take a loan from you parents. They tap into their home equity, of which the repayments will come out of your eventualy rent CF (this is why it is important to +CF). Secondly, then apply for a loan through one of the lenders. (Suggestion buy Mortgage magazine), as you may have probs getting finance from one of the big 4, but others (such as credit unions), are more willing to take up loans.

You could also put a proposal to your parents (or anyone for that matter) and go into a 50/50% arrangements, with the understanding that the deposit component will be paid out of rent cashflow, by yourself (that second job), or out the capital gains once you sell. If you wrapped the property (the maybe the 1st home buyers grant) may contribute to part of that.

Once again, without knowing your whole situation, I could just be telling you to suck eggs. Hope this might give you a few ideas. Suggest you purchase Steve’s tale from trenches. Some excellent stories and solutions to invest in.

Michael Maddy
[email protected]
Canberra, Aus