Author Topic: Should I pay interest during loan grace period?  (Read 2813 times)

Ynari

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Should I pay interest during loan grace period?
« on: March 03, 2015, 11:18:04 PM »
I have some subsidized student loans currently in their 6-month grace period.  Two of them don't accrue interest during the grace period, but the other two do with a 3.4% and 3.9% annual interest rate, since they changed the grace-period interest policy halfway through my attendance.

The exit counseling suggested to "pay interest during the grace period to avoid having interest capitalized onto the loan" or something to that effect.  But is it mathematically beneficial to do so?

innkeeper77

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Re: Should I pay interest during loan grace period?
« Reply #1 on: March 03, 2015, 11:25:39 PM »
What is your plan for the loans? Are you going to just pay minimums, or are you going to get rid of them as soon as possible? 3.9% isn't a bad interest rate, that is in mortgage territory, and you could argue it is better to keep the loan and invest all of your other money. What is the interest on the two fully subsidized loans?

I wish our student loans were that low.. I would be only paying minimums at those rates personally, but that isn't for everybody.

Cathy

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Re: Should I pay interest during loan grace period?
« Reply #2 on: March 04, 2015, 12:04:41 AM »
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.

MonthAssetsLoan BalanceNet Worth
15000100291.67-95291.67
210029.17100583.33-90554.17
315087.67100875-85787.33
420175.68101166.67-80990.99
525293.37101458.33-76164.96
630440.92101750-71309.08
732071.3398499.61-66428.28
833711.2695239.75-61528.49
935360.7591970.37-56609.62
1037019.8788691.47-51671.6
1138688.6685402.99-46714.33
1240367.1982104.93-41737.74
1342055.5178797.24-36741.74
1443753.6775479.91-31726.24
1545461.7572152.91-26691.16
1647179.7868816.2-21636.41
1748907.8465469.75-16561.91
1850645.9862113.55-11467.57
1952394.2658747.56-6353.3
2054152.7455371.75-1219.01
2155921.4751986.093935.38
2257700.5248590.569109.96
2359489.9545185.1314304.82
2461289.8241769.7619520.06
2563100.1938344.4424755.75
2664921.1234909.1230012
2766752.6731463.7835288.89
2868594.928008.3940586.51
2970447.8824542.9345904.96
3072311.6721067.3551244.32
3174186.3317581.6456604.69
3276071.9314085.7761986.16
3377968.5310579.6967388.83
3479876.197063.472812.79
3581794.983536.8478258.14
3683724.96083724.96



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.

MonthAssetsLoan BalanceNet Worth
14708.33100000-95291.67
29444.13100000-90555.87
314207.56100000-85792.44
418998.77100000-81001.23
523817.93100000-76182.07
628665.2100000-71334.8
730346.2696805.52-66459.26
832037.1393601.72-61564.59
933737.8790388.57-56650.71
1035448.5287166.06-51717.54
1137169.1683934.14-46764.99
1238899.8380692.8-41792.98
1340640.677442.01-36801.41
1442391.5274181.73-31790.22
1544152.6570911.95-26759.3
1645924.0667632.63-21708.56
1747705.864343.74-16637.94
1849497.9461045.26-11547.32
1951300.5357737.16-6436.63
2053113.6354419.41-1305.78
2154937.3151091.983845.33
2256771.6347754.859016.78
2358616.6544407.9914208.66
2460472.4341051.3619421.07
2562339.0437684.9524654.09
2664216.5334308.7129907.82
2766104.9830922.6335182.35
2868004.4427526.6840477.77
2969914.9924120.8145794.18
3071836.6820705.0251131.66
3173769.5817279.2656490.32
3275713.7513843.5161870.24
3377669.2610397.7367271.53
3479636.196941.9172694.27
3581614.583476.0178138.57
3683604.52083604.52



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.
« Last Edit: March 04, 2015, 12:31:02 AM by Cathy »

Mrs. Healthywealth

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Re: Should I pay interest during loan grace period?
« Reply #3 on: March 04, 2015, 07:23:09 AM »
It also depends on if you want to be debt free. I had a loan with a 2% interest, paid interest and principal in the grace period. Paid it off in 1-2yrs (50k). It would have been more cost effective to just keep paying monthly, and invest the rest.  Personally, I hate debt so I got rid of the loan. Do I regret it, nope...cause now I pour all my $$ into investments and don't never have to think about what I owe. There is peace of mind in that.



Prairie Stash

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Re: Should I pay interest during loan grace period?
« Reply #4 on: March 04, 2015, 08:32:21 AM »
I have some subsidized student loans currently in their 6-month grace period.  Two of them don't accrue interest during the grace period, but the other two do with a 3.4% and 3.9% annual interest rate, since they changed the grace-period interest policy halfway through my attendance.

The exit counseling suggested to "pay interest during the grace period to avoid having interest capitalized onto the loan" or something to that effect.  But is it mathematically beneficial to do so?
The exit counselor gave excellent advice. Avoid lifestyle creep and start putting the money aside; either in investments or payments.

I paid off my loan (it had a floating interest rate, after tax deductions it was around 4.5%). The benefit was it decreased my monthly debt obligations so I could qualify for a home loan. Without knowing the whole story though it would have been appropriate to say the math dictated investing over payments. In my case my NW increased faster by paying off debt and opening up opportunities.

Don't ask for advice in isolation, the whole story matters.

Ynari

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Re: Should I pay interest during loan grace period?
« Reply #5 on: March 04, 2015, 10:46:03 AM »
Thanks, everyone. I think I'll wait until the loans become due to start paying them, but Cathy's math has shown that it also will make only a small impact on my net worth, so it's just as much a matter of debt preferences and what would be better contextually.

Context is that the loans are relatively small:
  • Stafford loan at $3500, 3.4%, subsidized interest until grace period ends in June
  • Stafford loans of $4500 and $5500, 3.4 and 3.9% respectively, interest accruing now, grace period ends in June
  • Perkins loans of cumulative $3600, 5%, interest-free grace period ends in October

I'm currently seeking employment, with best-case scenario being an April start date and worst-case probably being in September (though I find it unlikely that it will take that long, it is still a consideration that I don't know when my search will end). So paying interest would require dipping into my emergency fund or my Roth IRA, which is not a risk worth taking unless the math of it worked out in my favor.

The current pay-off plan is to pay off the Stafford loans according to the standard 10-year amortized plan, but pay off the Perkins loan ASAP (hopefully, by the end of this year).

rocketman48097

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Re: Should I pay interest during loan grace period?
« Reply #6 on: March 04, 2015, 01:49:13 PM »
Subsidized loans are a true gift from God.  I had them, and they were great.  Due to the unfortunate situation of my dad dying at 17, and being one of five kids, 3 of which were in college all at once and my mom being flat broke, I also got:

Pell Grants
SEOG grants
State specific needs based grants.

College was like a vacation for me, but I am sure I will enjoy early retirement just as much (now 38).