Student Loan Repayment, Pt. 3: compound interest will be the death of us

Okay, we’re back to the surprisingly serious blog series I accidentally started this week.  This is Part 3, so be sure to check out Part 1 and Part 2 so you are up to speed. 

One of the most important features about student loans is deferment:  while you are in school, you don’t have to make any loan payments or even pay the interest on your loans.  Any interest you do not pay is added to the principal of your loan.  This is called compound interest.  Every day that you aren’t paying interest your loan is actually getting bigger.

And while we’re in school, this is probably the greatest thing about student loans.  Right?  I mean, I lived for two years in Washington, D.C. [this is pre-wedding] on what amounted to 20,900 cash monies annually plus whatever part-time work I scraped up at school.  That’s all I had for rent, food, clothes, travel, cable/internet, everything.  And honestly, I lived pretty comfortably, even though rent alone was $1100.  [My parents raised me to manage my funds well.  Thanks, parents.]  But, knowing that my extra cash was so low, imagine how easy and oftentimes necessary it is for students to take out maximum student loans and add on extra private loans just to get by.

While you are in deferment, your loan amount grows according to this formula:

[Loan Amount]*((1+(interest rate/365))^(365*[years in deferment]))

So, if you take out a loan for 20,000 at a rate of 7% and then wait 3 years before starting to make payments, your “principal” will actually be $24,398.29.  And if you then take your six month “grace period,” you will suddenly owe $25,267.27.

But, here’s the thing — you don’t get to take that $20,000 out just once.  You have to take it out every year.  So, your second year of $20,000 turns into another $23,559.20 and your third year of $20,000 turns into 21,966.66.  So, when your grace period ends and it’s time to start paying back your loans, the $60,000 you needed to pay for school is already $70,793.08.  And if we were being more realistic, we’d be increasing the loan amounts by about 10% each year to match tuition/fee increases.  But let’s not put too many variables into play at once.

That’s right, you haven’t even started making payments yet, and you already owe $10,793.08 more than you borrowed.

Now, if you can afford to make the Standard Payments to pay off your $70,793.08 in ten years, you will pay approximately $820/month for ten years.  I used a standard mortgage payment calculator on the interweb because I am not trying to burn my brain into mashed potatoes with unnecessary math.  I mean, this is starting to get out of control.  By November 2021, your debts will be repaid and you will be free and clear.  After making your final payment, you will have paid the government $97,095.47.

Yes, let’s say that again:  $97,095.47.

This number is calculated according to the following formula:

Add end values for all 3 loans to consolidate into one loan amount of $70,793.08.

Subtract the monthly payment you will make:  70793.08 – 820.  Let’s call this A.

Determine the amount of interest you will pay:  (A) * (rate)/12.  Remember, our rate is 7%.  So, this looks like A(.07)/12.  Let’s call this value B.

To determine where you are at the end of the month, you’ll add A and B.  Each month for 120 months, you’ll redo this calculation to determine how much interest you are paying over the course of your ten year loan.  You should do what I did and create a spreadsheet so you can copy and paste a formula.  Because honestly, do you really want to do 120 math problems by hand?  I didn’t think so.  My formula looked like this:  =(A1-820)+((A1-820)*0.07/12).

So, you are paying $37,095.47 more than you originally borrowed back to the government.  That’s more than 50% of what you borrowed.

It’s a little overwhelming, right?  And this is if you pay the maximum amounts — you’ll be paying more in the long run on ICR, IBR, or extended payment plans.  We’ll get to that, but this is a lot to take in for one post.

I’ll leave you with a quote from Michael Lewis’ The Big Short: Inside the Doomsday MachineHere, he is describing credit default swaps of subprime mortgage bonds:  “He found one mortgage pool that was 100 percent floating-rate negative-amortizing mortgages—where the borrowers could choose the option of not paying any interest at all and simply accumulate a bigger and bigger debt until, presumably, they defaulted on it.” (Lewis, 52.)

It seems a bit similar, doesn’t it?

Please Note:  I’m not quite ready to have an opinion about what all of this means. I don’t have any endgame at play for what the right solutions will be, because I think we first need to identify what is causing our problems. So, if you have insight into better questions to ask please do send me a message or leave a comment here.  I hope to come to some recommendations by the end of this but I’m just not there yet. 

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5 comments

  1. Pingback: Student Loan Repayment, Pt. 3: compound interest will be the death … | Student Loan Deferments
  2. Pingback: Going into debt: my story (abridged version) « pinkbriefcase
  3. Pingback: Open and Exposed « pinkbriefcase

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