What is interest?
Interest is your source of pain as a debt holder and the purpose of investing. As a borrower, interest reflects your charge from lenders in order to use their money. It’s also the source of their profits.
When you take out a loan, the balance is called the principal. When you borrow money, interest accrues on the principal based on the loan’s interest rate, which is usually expressed as an annual percentage. A loan of $100,000 loan with a 5% interest rate accrues $5,000 a year. As we discussed, your medical school student loans begin accruing interest immediately when you get them, even while in school.
The Rule of 72
As a fun aside, the Rule of 72 is helpful shorthand to determine the approximate doubling time of an investment (or the doubling time of your loans while you’re not making payments like when you’re forbearing). Simply divide 72 by your interest rate: that’s the number of years it will take. For example, at 6%, an investment (or unpaid loan) takes 12 years to double.
The cost of Starbucks
Personal finance gurus love to talk about the financial drag of a Starbucks habit on your budget/savings/you-name-it. It’s on every top 10 list on every blog that has ever mentioned the word “money.”
So, to pile on, let’s consider the cost of a $4 Starbucks latte purchased with an unsubsidized loan during your first year of medical school with a 6.8% loan. After 4 years, it’s now about $5.20. After a standard ten-year repayment, those four bucks you borrowed cost you $10. And then you still have to pay that $10 with after-tax money (so closer to $12-15 of earnings). Now it’d be less dramatic for coffees purchased with money held less long, and of course, inflation reduces the effect a fair bit (a 2% inflation rate makes it about $7.70 once adjusted)—but it’s still something to consider. When you borrow for tuition and cost of living, your entire life is a loan. The whole thing. You can cut coupons, but no matter the good deals you get, you may still end up paying double for every latte or burrito.
So even if this example is a bit silly, it does serve to illustrate the point: those loans may come easily, but they don’t come cheap. And hey, if future-you wouldn’t bat an eye at a $10 latte, then sip away.
Compounding and capitalization are actually the same process, referred to as the “eighth wonder of the world” by none other than Albert Einstein. Capitalization occurs when accrued interest is added permanently to the principal, thus making the principal larger. That larger principal now grows interest faster than the original smaller amount. If this compounding happens on a regular basis, the loan grows faster and faster. This is the magic. As Benjamin Franklin said, “Interest never sleeps.”
Compounding is what this phenomenon is called when referring to investment growth (a good thing), and capitalization is what it’s called when it comes to debt (a bad thing).
To illustrate, imagine a $200,000 unsubsidized loan with a 5% interest rate after a one-year forbearance. The loan accrues $10,000 in interest (200,000 x .05) over the year. At the end of forbearance, the accrued interest is capitalized such that the new principal is $210,000. The loan now accrues $10,500 every year until payments are large enough to pay off the interest and start reducing the principal.
Since many residents’ payments are not large enough to cover the accrued interest, that extra $500 per year from that one-year forbearance could happen for several years. Your loans capitalize at the end of your six-month grace period, so unless you have enough money to magically pay off all the interest that accrued while you were in school, you’ll be feeling the effects of capitalization at least once.
As we mentioned in the above example, capitalization is one of the costs of choosing loan forbearance to avoid making payments. Most folks are limited to a three-year maximum, but as a trainee, you don’t have that limit. You can be the proud recipient of the mandatory medical residency forbearance, which is mandatory in the sense that they are mandated to give it to you if you ask (not mandatory that you take it).
Amortization is the process of how your loan is paid off gradually over a specified amount of time with the same size payment. Early on, the majority of your payments cover interest with a small amount applied to the principal. Over time though, the fraction of each payment going toward the loan itself continues to increase as the loan balance decreases and thus the daily interest decreases. This is exactly how mortgages work, and it explains why homeowners have very little equity in their homes for several years despite making what seem like large payments. Most of it is going to interest so that the bank can get its due.
Negative amortization is what happens when your monthly payments are insufficient to cover the accruing interest. Thus, despite making regular payments, the total amount owed continues to increase. This is a frustrating situation for borrowers, and in the context of medical student loans, very common during residency. That’s because income-driven repayment plans cap your monthly payments at a reasonable level and your debt is frequently unreasonably large.
For example, a single resident with an AGI of $55,000 a year will have a monthly payment of around $308/month under the PAYE or REPAYE repayment plans, so about $3,700 a year. An average $190,000 loan at 6% accrues $11,400 in interest per year, which means $7,700 would be unpaid. Despite what’s felt to be an affordable monthly payment, that loan is only getting bigger. Negative amortization: Ouch.
Fixed vs variable rates
All federal Direct loans are fixed-rate, which means that the interest rate is set at the time of origination and will never change. You know exactly how much interest will accrue for a given loan amount over a given amount of time.
Private loans or privately refinanced loans can be fixed or variable. Variable-rate loans, like adjustable-rate mortgages, have rates that are tied to some external measure and can change over time. When the LIBOR (London Interbank Offered Rate)—or some other benchmark reflecting the rate that banks borrow from each other—goes up, your rate also goes up. This introduces some risk, and as a result, the offered rates are lower as an enticement. There’s no free lunch. Whether or not that risk is worth it depends on several factors, including how much lower the variable rate is, how fast the rate can change, how fast you plan on paying off your loans, and how much faster you can pay them off if the rates increase rapidly. Interest rates are still basically at historic lows, but it’s imprudent to make predictions about rate changes. It’s like predicting the stock market. Anyone who is willing to tell you how to do it, if they really could, wouldn’t be telling you. If as an attending you’ll be making enough money that you could hunker down and pay your loans in a year or two, then the risk is negligible. If the ten-year standard is instead looking just on the cusp of doable, then it’s probably better to stick with fixed.
Longer repayment always means more cost
Interest doesn’t have duty hours. The longer it takes you to pay off your loans, the more interest accrues, and the more interest you’ll have to pay. When you pick a plan with lower payments and a longer repayment period, you also resign yourself to paying more money in the long run.
How student loan interest actually works
While we often talk about annual interest, it’s worth pointing out that federal student loan interest actually accrues daily. To determine your daily interest rate, divide the rate you have by 365. 6% APR is 0.0164% per day, so a $200,000 loan at 6% accrues about $33 a day in interest (200,000 x .000164) (more than your Starbucks and Chipotle by a long shot).
On the plus side, there is a 0.25% interest rate reduction when you auto-debit your monthly payments from your checking or savings account. So there’s that. Once you’re actually paying money every month, the rate will be a quarter-point lower.