subsidized loan at 8% versus unsub at 6.8%

[HudValNY]

<p>I totally agree with Calmom that choosing a subsidized loan is the way to go given these rates. Even if you NPV’d the payments at realistic interest rates, the subsidized loan would be optimal. But, the ‘interest holiday’ is the great gift. Another way I look at it. Assume that one borrows $4,000 of loans for each of 4 years (say, 2011/2 - 2014/5) for a total of $16,000 in loans. The amount to be repaid when due in 2015 (after 48/36/24/12 months) would only be $16,000 in a subsidized loan (due to the interest holiday). The total 4-year loan amount in an unsubsidized loan scenario would have grown to $19,010.30 @ 6.8%. So, the interest holiday could be worth $3,010.30 in the above example. </p>

<p>6.80% Accr’d Int per 1K For $4,000
2011/2 Loan 311.58 1,246.32
2012/3 Loan 225.59 902.37
2013/4 Loan 145.24 580.97
2014/5 Loan 70.16 280.64
Total 752.57 3,010.30</p>

[mathmomvt]

<p>

That is, let’s suppose he borrows $4000 of unsub loans. By your math, he is paying $272 per year in interest payments. That’s a small amount – but the point is that borrowing $4000 in unsub, with the payments, is really the equivalent of borrowing $3000 in subsidized loans, when you weigh in the 4 years of payments. And of course 8% interest on $3000 is less than 6.8% interest on $4000.

</p>

<p>Just a quick correction – the $272 was for all 4 years of I/O payments</p>

[HudValNY]

<p>True mathmomvt. But, that amount is also one year’s worth of I/O payments on a $4,000 loan.</p>

[calmom]

<p>mathmom, you chose to calculate numbers for each $1000 worth of debt. We will call that P.</p>

<p>I went back to your first post to look at the amount your son was actually considering borrowing, and settled on $4000 in my example. We will call that 4P.</p>

<p>Interest on P for 4 years at 6.8% is:
0.068 x P x 4</p>

<p>Interest on 4P for 1 year is</p>

<p>0.068 x 4P</p>

<p>Same number. </p>

<p>Now here’s the reason I wanted to deal with the real loan amount.</p>

<p>People often make poorer choices when looking at symbolic rather than real numbers. This is especially true when it comes to percentages. I can look at the problem you set out in the beginning and don’t have to do any math. It is obvious to me that the subsidized loan is best. But that’s just the way my mind works – I automatically turn the numbers round in my mind when I look at them. The thing that was took some doing was to work out mathematically how low the interest would have to be on the unsub loan to give you the same benefit as the subsidized loan. That’s a harder math problem because I have to account for the declining balance of the loan once the pay off starts – if I didn’t have to do that it would be a simple matter of averaging the rate for 10 years over a period of 14 years.</p>

<p>But coming back to the reason I want to use real number. It is easy for you to look at $272 (4 years interest on $1000) and kind of think, "no problem, that’s not a whole lot of money). But if your son borrows $4,000, then it’s not $272 in interest, its $1,088 in interest. So the real problem becomes: which costs more, a loan for $4000 at 8% interest or a loan for $5,088 at 6.8% interest. To me it seems obvious that 8 x 4 is less than 7 x 5, which is my quick & dirty mental math applied to the problem. If you actually do the math, then you are comparing a first month’s interest payment of $26.67 (at 8%) with a $28.83 (at 6.8%). Of course that’s without making the interest payments during the first 4 years – but the point is that your son pays that extra money one way or another. </p>

<p>Here’s one more question for you to ask. A Stafford subsidized loan is great because the loan payments go into deferment status if the student is enrolled in grad school. But your son has been offered a subsidized loan from Cornell - so the same rules may not apply. So you might want to look into that. Keep in mind that that your son is looking at 4 years of borrowing, and that the financial aid package he gets each year will probably put a somewhat increasing loan burden on him. So it is very realistic to think that after 4 years, he may have $20K in loans. If he wants to go to grad school, the issue of whether he has to begin making payments right away or has an option to defer might be a very big deal.</p>

[mathmomvt]

<p>

Now here’s the reason I wanted to deal with the real loan amount.</p>

<p>People often make poorer choices when looking at symbolic rather than real numbers.

</p>

<p>But it really doesn’t make a difference in this case because it was just comparing 2 types of loans, not deciding how much debt he should take on, which we already decided (using real numbers) earlier.</p>

[mathmomvt]

<p>

Here’s one more question for you to ask. A Stafford subsidized loan is great because the loan payments go into deferment status if the student is enrolled in grad school. But your son has been offered a subsidized loan from Cornell - so the same rules may not apply. So you might want to look into that.

</p>

<p>Again, this is a detail that it helps to know, but it doesn’t make any difference in choosing between the options he has on the table. </p>

<p>The amount of debt he is planning on is on the high side: $7500/year for 4 years (i.e., $30K). We know that. He may be able to get away with a bit less debt if he can earn more in future summers or co-ops, but of course that also reduces his need-based grants first, so he may need to take the full $30K. We did the full analysis on that given the loan types he was offered and decided that that is a reasonable amount for him given his career plans. Of course things could change and that could end up being a mistake, but we agree with him that it is a reasonable risk. He had other lower cost options (merit scholarships) but made this choice with his eyes open.</p>

[calmom]

<p>

But it really doesn’t make a difference in this case because it was just comparing 2 types of loans, not deciding how much debt he should take on,

</p>

<p>OK, but then it was obvious from the get go that the subsidized loan is a better deal and and that the interest rate differential of 1.2% wasn’t enough to compensate for the 4 years at 0 interest. So why did you even have to ask?</p>

<p>It’s kind of like going to a store to buy a blouse where there are a lot of items are on sale, and not having a particular preference between two blouses, but choosing to buy the $50 blouse with the 40% off tag over the $30 blouse with the 20% off tag, because 40% off seems like a much better discount than 20%. </p>

<p>I’m not trying to insult you – I’m just pointing out that if you simply run the full figures and look at dollars in real terms (not as fractions, not as percentages), then there really isn’t any question as to which is the better choice. </p>

<p>The answer to the question may change with a higher interest differential or down the line – for example, in your son’s senior year, when he is looking at only a 1 year deferment in interest payments. </p>

<p>Who is going to be making those interest only payments while your son is in school? I supposed if you are going to pick them up for your son, either directly or indirectly (such as by sending your son a larger monthly allowance) – then from your son’s perspective the 4-year subsidy wouldn’t make a difference. But if your son is making those interest payments on his own and has to work for the money – then a $22 monthly interest payment probably requires 2-3 hours of work, depending on pay rate; and in year #2 that payment burden doubles – so each year more and more of his earnings are going to to service debt. What if he wants to take an internship or study abroad? </p>

<p>Another question: in your first post, you wrote, “His financial aid package includes 3500 in Stafford Unsubsidized loans and 4000 in Cornell University loans.”. Now you say he’s going to borrow $7500 every year. So your real question isn’t between taking one loan or the other, it’s $4000 subsidized + $3500 unsubsidized – vs. $2000 subsidized + $5500 unsubsidized (assuming that he can opt for the full $5500 in unsub stafford).</p>

<p>I’d look at that problem in the short term rather than long term, and treat the Cornell loans as having 0 interest. That turns it into looking at paying $238 to service first year debt vs. $374 to service the same amount of debt. </p>

<p>It’s true that, assuming that the interest payments are made, then after graduation the payments are going to be lower if the balance was struck in favor of the unsubsidized, lower rate loan. But after graduation your son’s earning capacity may be greater, whereas right now he is looking at actually making those payments. Plus a lot of things may happen post-grad that will impact his ability to pay off the loans. The faster he can pay them off, the less of a difference the interest rate will be. And it won’t be looking at an interest rate that is 6.8% vs. 8%. Assuming that the numbers hold steady over 4 years, it will be looking at </p>

<p>$16,000 @ 8% + $14,000 @ 6.8% (roughly 7.4% interest rate)</p>

<p>or</p>

<p>$8,000 @ 8% + $22,000 @ 6.8% ( roughly 7.1% interest rate)</p>

<p>I personally don’t see the 0.3% interest rate differential as being that significant in terms of planning, given the reality that over the life of the loans there are all sorts of changes your son might make that would impact the amount he actually pays in interest.</p>

[mathmomvt]

<p>

OK, but then it was obvious from the get go that the subsidized loan is a better deal and and that the interest rate differential of 1.2% wasn’t enough to compensate for the 4 years at 0 interest. So why did you even have to ask?

</p>

<p>I was asking if there were any factors I was missing before running the numbers. </p>

<p>

The answer to the question may change with a higher interest differential or down the line – for example, in your son’s senior year, when he is looking at only a 1 year deferment in interest payments.

</p>

<p>good point, especially about the shorter deferment as he goes forward</p>

<p>

Another question: in your first post, you wrote, “His financial aid package includes 3500 in Stafford Unsubsidized loans and 4000 in Cornell University loans.”. Now you say he’s going to borrow $7500 every year. So your real question isn’t between taking one loan or the other, it’s $4000 subsidized + $3500 unsubsidized – vs. $2000 subsidized + $5500 unsubsidized (assuming that he can opt for the full $5500 in unsub stafford).

</p>

<p>Yes, that was exactly my initial question:</p>

<p>

I assume, if he wanted to, he could take the full 5500 in Stafford loans and take less in Cornell loans…Are there other factors we should be considering here? I can make a spreadsheet to run a few scenarios, but I’m wondering if I’m missing any considerations.

</p>