Advice on paying interest on staffords while in school

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tapir

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I'm a new veterinary student, and my first semester's staffords have just been disbursed (I'm married with a working husband, and only needed staffords; about 10% less than the stafford max). I've elected to pay interest on the unsubsidized portion while in school rather than having it accrue and capitalize, which means that I will borrow more than I would otherwise have, as I will need more cash monthly in order to pay this interest. My thinking was/is that even though the higher principal borrowed will mean more interest to be paid, this is more than compensated for by the tax benefits of paying off interest while in school (i.e. deducting the interest paid).

I wanted to check my logic with the folks here before I actually start making monthly interest payments, and while it's still easy to reverse my decision. Any advice would be appreciated. Thanks!

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This is a very good question and something that I get pretty foggy about. My lender does not capitalize the interest that accrues in the unsubsidized staffords until you enter repayment, so paying the interest on the unsubsidized staffords now doesn't make sense for me. However, I guess I might be stuck with a pretty big interest payment once I start repayment to avoid this capitalization.

But I'm not sure if this is true with all lenders. I'd suggest looking at the fine terms of your lender agreement or maybe calling your lender to ask when they capitalize the interest. I'll do a little more research, too, and report back.
 
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Interesting! That's good info, thanks. Given that, and without talking to my lender for now, I'm going to assume that the interest does not capitalize until repayment, at which time all four years' interest would stack on top of the principal at once. That means the interest is not accruing interest on itself until repayment, right?

If that's the case, should it impact my decision? It's fuzzy to me too, and feels circular.

EDIT: Here's an archived thread with the same question - http://forums.studentdoctor.net/archive/index.php/t-40787.html.

The consensus there seems to be that one should pay the interest in one lump sum just prior to repayment, but they don't seem to have considered the tax issue (I'm sure I'll be paying enough interest in repayment to hit the $2500 deduction limit every year). But if I'm borrowing more to allow me to pay the interest, maybe that trumps the tax issue. Circular!
 
Yeah, the whole paying money now with money you're currently borrowing seems a little weird. You're right about the tax issue, though, and that might take some more calculations. If your spouse is working, it's possible you could deduct your current interest payments from his income so you could somehow calculate it out so you pay no more than $2500/year in interest payments.
 
Interest on your Unsub capitalizes each time a loan enters repayment which would begin 6 months after you stopped going to school. If you were to attend for 4 years with no breaks of greater than 6 months then your interest on your Unsub would capitalize 4 years and 6 months out. I wouldn't be in a rush to pay it. I'm not sure it would be an advantage to borrow more to pay interest on it for a tax deduction. Keep in mind that once your combined income hits around $110,000 the deduction starts to phase out. What I would do is simply do a 1040 both ways and see if it's worth it. Student loan interest paid by you is also any loan fees charged by the lender and not just the interest accrued so you may already have a deduction just from the fees alone, albeit small.
You may also be eligible for an education tax credit (www.irs.gov find form 8863 for a lifetime learning credit. There's also a tuition deduction up to $4000 but you'd need to look at tax stuff for 2005 to find info-- the IRS printed 2006 tax stuff before the deduction was reauthorized so you won't find anything in 2006). The tax credit or deduction may wind up simply nullifying your federal tax liability to begin with.
The beauty of federally backed loans is not the rate which most students miss and I'm not sure why my profesion can't get past the "don't borrow, don't pay interest school of thought. Any federally backed debt you have is forgivable upon your death of total disability (no risk to your spouse). It is also very flexible when payback time comes. For example: you have a mortgage for $200,000 at 5.75 and federally backed Sub/Unsub for $150,000 at 6.8 and you are out of work for 4 months. A mortgage doesn't care: you owe the money and it has to be paid and if you don't, your house is sold to someone who can. With your federally backed loans it is highly likely you could request a forebearance for several months (no payments due) until you got back on your feet. Yes, you would be responsible for the interest but your life isn't ruined. Sub/Unsub come with several repayment options as well. I would be whacking my money into my mortgage and not my federally backed higher rate loan--- weigh the risk factor and insurance costs for the mortgage and not just the rate.
Consider a longer ranging plan... If you are in school for 4 years, have you anything in retirement? If not, maybe borrow a bit more so your husband can take some of his income and contribute to a Roth IRA on your behalf... It's pretty much what I would discuss with my DMD kids in your position. It is highly likely that your combined income after you graduate will preclude you from a student loan interest deduction and a Roth as well.
There's always the house fund... Would you be better off in the long term leaving school with a good sized down payment for a house and not have to pay PMI (private mortgage insurance) or do an 80/20 split and entering the market several years earlier or graduating, working and saving for a few years and then buying? I realize the mortgage interest is deductible but again, weigh the risk of the debt and take into account it is most likely an appreciating asset that could be liquidated or leveraged against if need be.
In short: think a bit more long term about borrowing and weigh the risk and not just the rate, deduction etc... Know why you are borrowing and keep that goal in mind.
 
Capitalized interest is also considered interest paid in the tax year it occurred so it may be sizeable the year you enter repayment.
 
Capitalized interest is also considered interest paid in the tax year it occurred so it may be sizeable the year you enter repayment.

Interesting. Do you mean that in tax year 4, when the interst would capitalize, I would be eligible for back-deductions for interest "paid" in tax years 1-3?

Thanks very much for the rest of your very thorough reply. You make a number of very good points about retirement, home down payments, etc., but I can't help feeling that would be 'robbing peter to pay paul' - my priority right now is doing the best I can to minimize my student loan debt.

In case anyone else, now or in the future, has the same question, we ran some spreadsheet comparisons comparing the benefits of paying the interest, paying toward principle, or paying nothing toward the loan while in school and earning savings/positive interest (5%) on the extra amount borrowed.

It turns out that the net results are all in the same ballpark, but that paying any extra money toward the principle each year, as long as you can afford to pay back a certain amount more more than the interest that accrues, is the most beneficial. If you do this by a certain deadline each year, any interest that had accrued on the amount of principle you give back is cancelled.

My calculations could be a little bit off, as it's a bit of a brain twister to try to get everything factored, but I'm confident at least that each of the alternatives are all in the same ballpark.
 
If you've already paid the interest over the years, there wouldn't be much to capitalize. Given your reply, I tend to think you'd be better off just borrowing less.
 
So question about the tax thing that might have been answered above. If I pay interest on my loans now as they're accumulating, could I deduct that interest from my taxes for this tax year? I know it doesn't get "capitalized" until repayment, which is several years off.
 
Whatever you pay in accrued interest during the tax year may be elgible for the deduction. The max is $2500 per year. Your lender should be able to furnish you with a 1098E that verifies the amount you paid.
If you borrowed last year, you most likely received one with a figure which in all probability was the total in loan fees skimmed off the top by your lender.
Your sub/unsub would have been 3% and a PLUS would have been 4%. You could do the math and see if the fees equal $2500 and then decide if you want to send a check for any interest.
Double check to see if fees paid for by the lender are tax deductible for you (I'm pretty certain they would be since they are all contingent upon repayment incentives).
 
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