The Magic of Compounding Interest on Student Loans

Below is a guest post by  Drewski. In addition to being my main squeeze he also used to work as a broker in New York City and currently helps teach brokerage exams. Aside from being uber qualified, as a graduate student he knows first hand the cold fist that is compounding interest. Read his thoughts on the subject below!

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I’m going to brag– I have pretty good credit. No outstanding debt and a pretty solid, albeit short, credit history.  So I was pretty surprised when applying for a loan to pay for my MBA I was told my variable rate will be 2.5% above the prime rate. I was expecting to pay the prime rate, or maybe a little over. This is not the good kind of surprise.

Now for y’all who don’t know, the prime rate is essentially the lowest rate that all the banks agree upon. So basically all the banks talk amongst themselves and agree to not compete with each other by setting this rate. That rate is currently at 3.25%. It has been since 2008 and doesn’t look like it’s going up any time soon. And just for reference the discount rate(the rate at which the banks are able to borrow from the Federal reserve) is at 0.75%.

Why did I choose a variable rate over a fixed rate? Well interest rates don’t seem to be going anywhere anytime soon. Ben Bernanke seems to think that low interest rates are the key to recovery. While he is the federal reserve chairman, or until he changes his mind about all of his policies, interest rates will be low. Until of course we recover economically. And since a lot of our issues are tied globally to Europe, I think it’s pretty safe to say that my rate of 5.75% isn’t going anywhere anytime soon. And if it does creep up before this is all paid off it has a ways to go to catch up with the Stafford loan fixed rate of 6.8%

So why did I choose a Discover loan? Basically they hook you up. Upon graduation I get 2% knocked off my principal. Of course interest is accruing from the point I pick up my check so if I take $50,000…. I would get $1,000 taken off the loan when I graduate. Of course I would have racked up almost $6,000 in interest due! But I’ll still take that $1,000.

The main point of this piece is to look at the actual cost of those interest rates. As an out-of-state student my tuition per semester is $16,052 (Although I’m still waiting on the results of an out of state tuition waiver…) I’m taking out two loans for my first year. One in the fall and one in the spring. Each loan is for $22,596.50 which will cover tuition plus my living expenses. At the end of the first semester that $22,596.5 will have turned into $23,130.45. And at the end of the spring semester, my first full year will cost me 46,591.50. That’s an extra $1,400 in interest added to the cost of my first year of school.

Now, I’m planning on doing anything possible to make sure I have an assistantship next year, so lets just assume that goes according to plan and my second year of grad school is free. At the end of my second year, my first year loan will have magically transformed to  $49,269. That’s an extra $4,000 just upon graduation when I can hopefully get a job to finally pay this thing off.

There’s no way for me to know how much money I’ll be earning when I do find a job, so it’s tough to calculate exactly how much I’ll be paying in interest on this loan. But it’s very important to realize that if I am fortunate enough to be earning so much money that I can pay it off in the first year it will cost me $52,101. That comes out to about $7,000 in interest. If you’ve been keeping tabs you can see that the first year cost me $1,400 in interest. The second year cost me another $2,600 and the third and ‘final’ year will cost me $3,100 in interest while I finish paying the loan off. This is the magic of compounding interest. It will keep getting exponentially higher unless you start paying the debt off faster than interest accrues.

No wonder the country is suffocated by debt. Real costs are staggeringly higher than stated costs. And those alone are pretty damn high.

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Thanks to Drewski  for the guest post! In case you missed it check out the guest post I did for Canadian Budget Binder  yesterday entitled “Going to Private School Affected my Finances”.

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13 thoughts on “The Magic of Compounding Interest on Student Loans

  1. The numbers can be shocking that’s for sure. Some people forget about good ole interest and how fast it can add up. When we get our credit card statement a mere $480 can take us over 1 year of minimum payments to pay off. One year OH MY GOODNESS… yes it’s no wonder people are getting further into the hole. Student loans are not bad loans in my eyes as you are investing in yourself BUT as you noticed that money can grow just as fast with interest if the principal is not being paid down.I feel for some students we know who have 60 or 70k in student loans and the best job they can find is retail at the mall. Nothing is for sure in life that’s for sure.

  2. Very interesting! I’m heading to law school and my interest rates will be 6.8% and 7.9% FIXED. I wanted to do federal loans because of any programs they may make in the future that might help me…then I’ll be able to consolidate and qualify. Everyone I know usually advises against private loans but that interest rate looks attractive. I still have 2 more years to take out loans, so I’d like to know more.

    What’s your repayment plan like? 10 years? 15? Have you compared all the benefits of federal loans to that of private loans? I’m not too familiar with the benefits of a private loan besides the lower interest rate – however it’s variable.

    • Honestly I have no idea what my repayment will be like. I’m making a pretty drastic career change(I have an undergraduate degree and part of a masters degree in music performance) and I’m very ignorant of what a base salary could be with an MBA in marketing. I did the math here based on 1 year. While that might not be feesible, I do plan to throw everything I have at the debt until it’s gone. I’m willing to wait a while to celebrate graduating and everything to be rid of the debt. A great vacation, new car or house would be so much more satisfying once I know that I have peace of mind of no other loans outstanding.

      I did look at both federal and private loans. As a grad student, I’m not eligible for a subsidized loan. That would have been the best option, even at 6.8% simply because I would only have the principal to pay at graduation, not any interest. In the long term the government will cut you more of a break than any private lender. Traditionally private loans have actually had higher interest rates than government loans. Although now that most students are able to qualifiy for government loans(since tuition has been going up very quickly) private lenders have been lowering their rates to compete with the government. A loan from Discover could be as low as 6.78% fixed. Though this is based on your credit score and could actually be several points higher. If you have poor credit, then a federal loan might be right for you. I choose the private loan because I knew what I was getting in to. I’m actually pretty scared to take out such a large loan and I know that it HAS to be paid off literally as soon as possible. I was sent a statement that had my projected total repayment cost of about $85,000(the interest would actually cost MORE than the borrowed money.) I think that was based off of 15 or 20 year repayment. But it’s pretty easy to see how compounding interest can get out of control if it’s not dealt with swiftly.

      And on a side note, interest rates just might go up in the fallout of the LIBOR scandal(or not, bankers never seem to get in trouble for their misdeeds, so this might continue on for some time.) So I, as well as anyone else with a variable rate loan, would have that incentive to pay it off ASAP.

      -Drewski

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  4. But if the government didn’t have student loans, less kids would go to college. In Mexico, there is no such thing as student grants or loans. And public education is not free, you pay tuition +books every year. We are very lucky!

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