The short answer is that with a long list of assumptions (discussed below), paying interest during the grace period is the mathematically suboptimal move.
Now for the details:
The general topic of prepaying loans has been discussed many times, but the specific question of the effect of the grace period hasn't been discussed as much, so I'll provide some comments on it.
You haven't fully explained the mechanics of the loans so I will have to make some assumptions.
Assume all of the following:
- You owe $100,000 right now, at 3.5% interest rate.
- After the grace period, the loan will be amortised over a period of 30 months consisting of 30 equal payments.
- If you pay the $1,750 in interest during the grace period, then the amount to be amortised is $100,000. If you decline to pay the interest during the grace period, then the amount to be amortised is $101,750. That is to say, I am assuming that the interest does not capitalise during the grace period, only after it.
- You can earn 7% on your assets if invested, compounded monthly.
- You have $5,000 in free capital coming in each month to allocate however you choose.
- After the grace period, you only ever pay the minimum on the loan, because that is optimal for reasons discussed elsewhere.
- At the start of the scenario, your net worth is -$100,000.
Let's compare the two scenarios: paying interest during the grace period; and not paying the interest.
With my list of assumptions, paying the interest makes you end up with
$83,604.52, whereas not paying the interest makes you end up with
$83,724.96, which is higher.
Here are the details:
Scenario 1: You do not pay interest during the grace period.In this scenario, the principal to be amortised after the grace period is $101,750. The term of the loan is 30 months.
Given all the assumptions above, in 36 months when you have repaid the loan in full (6 months of grace period + 30 months of payments), your net worth will be
$83,724.96.
Here is a table showing how things play out over the 36 months in Scenario 1. Each row shows the balances after that many months.
Month | Assets | Loan Balance | Net Worth |
1 | 5000 | 100291.67 | -95291.67 |
2 | 10029.17 | 100583.33 | -90554.17 |
3 | 15087.67 | 100875 | -85787.33 |
4 | 20175.68 | 101166.67 | -80990.99 |
5 | 25293.37 | 101458.33 | -76164.96 |
6 | 30440.92 | 101750 | -71309.08 |
7 | 32071.33 | 98499.61 | -66428.28 |
8 | 33711.26 | 95239.75 | -61528.49 |
9 | 35360.75 | 91970.37 | -56609.62 |
10 | 37019.87 | 88691.47 | -51671.6 |
11 | 38688.66 | 85402.99 | -46714.33 |
12 | 40367.19 | 82104.93 | -41737.74 |
13 | 42055.51 | 78797.24 | -36741.74 |
14 | 43753.67 | 75479.91 | -31726.24 |
15 | 45461.75 | 72152.91 | -26691.16 |
16 | 47179.78 | 68816.2 | -21636.41 |
17 | 48907.84 | 65469.75 | -16561.91 |
18 | 50645.98 | 62113.55 | -11467.57 |
19 | 52394.26 | 58747.56 | -6353.3 |
20 | 54152.74 | 55371.75 | -1219.01 |
21 | 55921.47 | 51986.09 | 3935.38 |
22 | 57700.52 | 48590.56 | 9109.96 |
23 | 59489.95 | 45185.13 | 14304.82 |
24 | 61289.82 | 41769.76 | 19520.06 |
25 | 63100.19 | 38344.44 | 24755.75 |
26 | 64921.12 | 34909.12 | 30012 |
27 | 66752.67 | 31463.78 | 35288.89 |
28 | 68594.9 | 28008.39 | 40586.51 |
29 | 70447.88 | 24542.93 | 45904.96 |
30 | 72311.67 | 21067.35 | 51244.32 |
31 | 74186.33 | 17581.64 | 56604.69 |
32 | 76071.93 | 14085.77 | 61986.16 |
33 | 77968.53 | 10579.69 | 67388.83 |
34 | 79876.19 | 7063.4 | 72812.79 |
35 | 81794.98 | 3536.84 | 78258.14 |
36 | 83724.96 | 0 | 83724.96 |
|
Scenario 2: You pay interest during the grace period.In this scenario, your net worth at the end of the 36 months would be only
$83,604.52.
Month | Assets | Loan Balance | Net Worth |
1 | 4708.33 | 100000 | -95291.67 |
2 | 9444.13 | 100000 | -90555.87 |
3 | 14207.56 | 100000 | -85792.44 |
4 | 18998.77 | 100000 | -81001.23 |
5 | 23817.93 | 100000 | -76182.07 |
6 | 28665.2 | 100000 | -71334.8 |
7 | 30346.26 | 96805.52 | -66459.26 |
8 | 32037.13 | 93601.72 | -61564.59 |
9 | 33737.87 | 90388.57 | -56650.71 |
10 | 35448.52 | 87166.06 | -51717.54 |
11 | 37169.16 | 83934.14 | -46764.99 |
12 | 38899.83 | 80692.8 | -41792.98 |
13 | 40640.6 | 77442.01 | -36801.41 |
14 | 42391.52 | 74181.73 | -31790.22 |
15 | 44152.65 | 70911.95 | -26759.3 |
16 | 45924.06 | 67632.63 | -21708.56 |
17 | 47705.8 | 64343.74 | -16637.94 |
18 | 49497.94 | 61045.26 | -11547.32 |
19 | 51300.53 | 57737.16 | -6436.63 |
20 | 53113.63 | 54419.41 | -1305.78 |
21 | 54937.31 | 51091.98 | 3845.33 |
22 | 56771.63 | 47754.85 | 9016.78 |
23 | 58616.65 | 44407.99 | 14208.66 |
24 | 60472.43 | 41051.36 | 19421.07 |
25 | 62339.04 | 37684.95 | 24654.09 |
26 | 64216.53 | 34308.71 | 29907.82 |
27 | 66104.98 | 30922.63 | 35182.35 |
28 | 68004.44 | 27526.68 | 40477.77 |
29 | 69914.99 | 24120.81 | 45794.18 |
30 | 71836.68 | 20705.02 | 51131.66 |
31 | 73769.58 | 17279.26 | 56490.32 |
32 | 75713.75 | 13843.51 | 61870.24 |
33 | 77669.26 | 10397.73 | 67271.53 |
34 | 79636.19 | 6941.91 | 72694.27 |
35 | 81614.58 | 3476.01 | 78138.57 |
36 | 83604.52 | 0 | 83604.52 |
|
The exact outcome will vary with the assumptions, but I suspect making payments during the grace period will typically be suboptimal. You might as well just do the math with your actual preferred numbers and assumptions to find out for sure.