Effective Rates of Negatively Amortized Federal Student Loans

Excellent post from my internet friend Dr. Sotirios Keros over at Doctored Money (a great non-profit non-conflicted site on physician finance and student loans), “Your Federal Student Loan Interest Rate May Be Lower Than You Think”:

Federal students loans are unlike other types of debt in that the interest is not capitalized except in certain circumstances. This means that your unpaid interest is not costing you anything. You still owe it, of course, but it represents “interest-free” debt. For example, consider an initial balance of $200,000 at 5%, which now has accumulated unpaid interest of $30,000. Although you owe a total of $230,000, interest only accumulates at $10,000/year. That’s an effective rate of 4.3% (e.g. $10,000/$230,000).

Seriously, check out the post.

Misunderstanding how federal student loan interest works is something I see wrong all the time, especially on the rare occasions I log into any of the physician finance-type Facebook groups. Accrued interest doesn’t hurt you in the short term unless it capitalizes. For example, rushing to make a token interest-only payment does nothing to change the natural history of your loans. That money can be leveraged–for example even just earning trivial interest in an online savings account–before being deployed more effectively.

The common advice from sites that make lots of money from student loan refinancing is that all graduating residents not doing PSLF should refinance. This seems logical because the private company sticker rates are nearly always less than the federal rates. But that’s not necessarily functionally true, because a resident whose loans spent years negatively amortizing likely has a big chunk of uncapitalized interest that’s doing nothing while in the federal program but will capitalize and earn its own interest after refinancing.

It may still be the right choice, but except in certain situations, you can’t just compare rates apples to apples and know you’re saving money.

You have to compare the effective rates!

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