The intention was to make the loans more progressive. The current student loans system was introduced in 2012 and implemented much of the proposals set out in the Browne Report, published in 2010.
The reason given for the use of an interest rate tied to inflation, rather than the Bank of England base rate, was that the loans should be based on the Government's cost of borrowing (as it's the Government providing the loan) - which is linked to RPI plus a certain percentage on index-based gilts. Browne dismissed the idea of financing loans from the private sector by predicting that banks would only agree to lend to students with a poor or blank credit history if they obtained a government subsidy, which would work out more expensive than direct government borrowing; "Government's cost of borrowing the funds to make student loans will always be lower than that of banks."
The interest rate on Plan 1 loans, taken out before the 2012 reforms, was the lower of either RPI or the base rate plus 1%. This, according to the Browne Report, created "perverse incentives around loan take up and fee deferral".
The current system does have some attractive features but
it does not produce progressive effects. No students pay
any interest on their loans. This means that even the
wealthiest students after graduation receive a subsidy from
Government – typically £3,000 – whereas that subsidy
could be targeted on students on lower incomes. Wealthy
students and families who understand the way the subsidy
works realise they are being paid by the Government to
borrow money and some will do so regardless of whether
they have a genuine need.
By contrast – because the current system is poorly
understood – many other students and their families are
worried by the fact that they run up debt by going into
higher education. In these discussions of debt, student loan
obligations are still grouped alongside credit card debts and
commercial mortgage style loans, as if they are all the same.
Browne's rationale was that low earners (currently those earning £27,295 or less) would accrue no further debt in real terms, while the system would incentivise higher earners and those with wealthy families who could afford to pay upfront to do so.
Families with high household incomes will be more likely to pay
upfront voluntarily and graduates with very high earnings will be more
likely to choose to make early payments to clear their obligation.
Both of these behaviours will ease the cash borrowing requirement for
Government, focus the Government support for students on those who
need it and make the Student Finance Plan as a whole more sustainable.
It will mean that the student from a wealthy household who goes on to
become a high earning graduate will no longer benefit from any public
subsidy. Even if this student took up the full amount of maintenance
loan for the costs of living and paid no fees upfront, the public
purse will receive in time payments equal to the net present value of
the costs paid by Government upfront.
At the other end of the earnings
scale, the targeted interest rate subsidy means that the outstanding
balance of low earners will not grow in real terms – and, if they
never earn enough to pay back the costs of living and learning, then
after 30 years these will be written off by Government.