Using SL's as forced savings?

[mui1080]

My brother recently graduated college. He borrowed the max amount on his loans for 3 years, even though he didn't need it. He laddered them in Cd's up to 5 years.

His reasoning is that it will force him to save money he would have blown on frivolous purchases ( which is true, unfortunately).
I however do not see the reason because he is only earning 2.75% and his interest rate on the SL's is something like 3.4%?

Granted he did pay on his loan while in school, so all his payments went to the principal and he does have 6 months of interest free payments left, but I think its a waste at this point because he's losing money. Its better to just discipline himself and apply the money to his savings himself.

I told him to cash out the remainder of the money not paid up yet and return it to SL.
I, however, am no expert so a little outside input will be greatly appreciated.

[dancinmama]

It's really a crap shoot. IF interest rates rise dramatically over the next few years (unfortunately, no crystal ball here), he could do REALLY well. If not, he'll take a loss. In the 80s we were earning 13% in a straight money market account.

[shanendoah]

If he has subsidized loans, while he was in school, and for the 6 month grace period, the interest is 0%, so in that case, earning any interest on them is making money. (And if he took out the max in subsidized loans, that's going to be right around $20k - anything more than that is unsub or private, and they are not interest free while in school.)
If he can pay off the loans before the 6 month grace period is up, he'll come out ahead. If not, then he might lose some money, but at least he has savings.
The one other good thing about SLs is that they are seen as good debt, and as long as he makes his payments on time, it can help build his credit score.

Still, I don't think this is the plan I would have taken.

[haapai]

It sounds like he has a down payment. It's borrowed, but it's not costing him a whole lot when you net out the amounts and take taxes into account.

[Clever Username]

Jun 2, 2011 11:22:46 GMT -5 dancinmama said:

If not, he'll take a loss. In the 80s we were earning 13% in a straight money market account.

I remember these rates.
Too bad I only got them applied to my passbook savings account with my birthday money in it.

Just out of curiosity.
At some level, lets say interest reaches 12%, do you just exclaim "Eurika!" and move your entire retirement nest egg into CDs? What's the longest period they sell those at?

[phil5185]

I however do not see the reason because he is only earning 2.75% and his interest rate on the SL's is something like 3.4%?

As you say, no mathematical basis for borrowing at 3.4% and earning 2.75%. But I continually borrow long term capital at <6% (mortgages) and invest that capital longterm at 11%/yr. Maybe he could use his SLs as the basis for a longterm wealth plan, ie, get rid of the CDs and place the money in investments. Don't know his particulars - but, eg, a $20k SL at 3.4%-fixed for 20 yrs would cost $27,600 ($115/m x 240m). The borrowed $20k placed at 11%/yr for 20 yrs = $161,000. And if he could leave the $161k untouched for another 10 yrs it = $460,000.

[HoneyBBQ]

I don't understand how he did this. I had to report ALL financial assets to the student loan office. If you had last year's loans sitting in a bank account you wouldn't qualify for any loans this year. I had to claim a measly $1000 in a ROTH IRA and they deducted that from my total granted amount.

[garion2003]

I'll second shanendoah - I hope those were subsidized loans.

[dancinmama]

Jun 2, 2011 13:18:24 GMT -5 Clever Username said:

Jun 2, 2011 11:22:46 GMT -5 dancinmama said:

If not, he'll take a loss. In the 80s we were earning 13% in a straight money market account.

I remember these rates.
Too bad I only got them applied to my passbook savings account with my birthday money in it.

Just out of curiosity.
At some level, lets say interest reaches 12%, do you just exclaim "Eurika!" and move your entire retirement nest egg into CDs? What's the longest period they sell those at?

Many people who are risk adverse (my sis and her DH) do CD ladders. This staggers the time when each chunk of money will be rolled into a new CD so you get gradual gains as rates rise, and gradual losses as rates drop.

I have no clue as to the longest period covered, but I'm sure it's googleable. (Oh, I think I just made up a word. )

[midjd]

I think if CD rates reach 12%, that means inflation will be at 13% or 14%, so you won't be gaining much...though if you can lock them in at that rate and then it drops, you'll be set!

[dancinmama]

Jun 2, 2011 14:03:27 GMT -5 midjd said:

I think if CD rates reach 12%, that means inflation will be at 13% or 14%, so you won't be gaining much...though if you can lock them in at that rate and then it drops, you'll be set!

That's why it's always a crap shoot. This is DEFINITELY the time to lock in a 30-yr mortgage.

[Tiny]

My local financial institutions (bank and savings and loan) offer 5 year CDs. There's 1, 2, 3, 5 years and then something like 30, 90, 180 day CDs and they usually have a 'special' CD with a special rate that could be any of the following: 7 month, 10 month, 14 month. A part of my EF is in CDs and I usually go with the special rate ones just for fun. I don't have enough money or CD accounts to do a true ladder.

[Tiny]

His reasoning is that it will force him to save money he would have blown on frivolous purchases ( which is true, unfortunately).
I however do not see the reason because he is only earning 2.75% and his interest rate on the SL's is something like 3.4%?

Isn't this just another way that people 'trick' themselves into saving money? Kinda like the person who uses their tax refund as 'savings'? He may not make money (because of the interest rates) but he will have a chunk of money free and clear once he's paid off the SLs. It's not about the money in the CDs making money - it's about the Big Pile O'Cash he'll have.

If you want to show the gain or loss you could set up an amortization table (or some other table-thingy) in Excel for the SLs and show how much in interest he'll pay. Then, do the same thing for the CDs showing how much money he'd earn. Compare the interest paid to interest earned. You can play around with the interest rates on the CDs in your example to see what rates make him money. Don't forget he pays taxes on earned interest...

Just a though... Right now 5 year CDs are earning less than 2% If interest rates go up in a few years he could be locked into low percentages for years on sone of his CDs. A shorter term ladder might be more to his advantage if he's 'betting' that rates will go up at some point in the next 3 to 5 years.

[dancinmama]

Jun 2, 2011 15:04:25 GMT -5 Tiny said:

His reasoning is that it will force him to save money he would have blown on frivolous purchases ( which is true, unfortunately).
I however do not see the reason because he is only earning 2.75% and his interest rate on the SL's is something like 3.4%?

Isn't this just another way that people 'trick' themselves into saving money? Kinda like the person who uses their tax refund as 'savings'? He may not make money (because of the interest rates) but he will have a chunk of money free and clear once he's paid off the SLs.

Depending on the length of the loan, it COULD end up being a great arbitrage. It's kind of like those of us who took balance transfers on credit cards at 0% (with no fees) and made interest off of it while we were making the minimum payments. At one time I had over $100K in "credit card debt".

Actually, for the person who just can't make themselves save money, these last couple of years would have been a really good time to overpay on their income taxes. With the dismal interest rates, they probably would have come out ahead.

[Deleted]

If he needs to trick himself into saving let him do it. It's a toss up how much interest he will make or lose in the short term, but he has said (and you agreed) that otherwise he would just waste the money. It seems to me that he knows himself and he's working with it instead of against it. Leave him alone.

[haapai]

If this guy has a 20% marginal tax rate (15% federal and 5% state), that 2.75% interest rate turns into something closer to 2.2%. The interest rate on the 3.4% student loan after taxes turns into something closer to 2.72%. (Technically, I should have annualized those rates before adjusting for taxes, but at such low rates it doesn't make a whole lot of difference.) When you subtract one from the other, he's paying a hair over one half of one percent annually to hold onto cash that he has at least 10 years to pay back.

Having a nice chunk of cash in the bank can make a lot of other financial moves very possible, even if it is tied up in multi-year CDs.

[msgumby]

My husband (then boyfriend) had to take out a lot of loans his first year of grad school (tuition of 30k - I covered his living expenses). They were all reputable, but only about half of them were interest free while in school. The next year (to his surprise) he still qualified for about 15k worth of government subsidized student loans, so he took those out to pay off the ones collecting interest. We were a bit surprised that he qualified for these loans because he had his tuition covered that year and was bringing in a paycheck - they just estimated his living expenses were way higher then they actually were. He was also offered a few thousand worth of non-subsidized loans, but turned those down. His third year, he was still once again offered about 15k worth of subsidized loans (and some non-subsidized ones), even though he didn't need any. He took those out again. After that he had too much in savings to qualify for enough loans to make it worth the effort. We saved our money through school with the intention of paying them off before paying any interest. We took our savings plus that extra loan and put it into cds (they were getting about 5% interest at that time and we were paying no interest on those loans). At that time, we were scared of losing the money because we were planning on using it soon-ish. As time went on, and I learned more about investing and money, we decided to move the money into a few mutual funds and have kept it there ever since. Based on timing, we have not gotten very good returns on this money, but we are at the point where we aren't in the negative and we have no intention of paying off those loans early.

Personally, i don't really think it's worth it to keep it in CDs, but I can understand not being comfortable putting into the stock market. Initially, I didn't really view the money as "ours" and was too risk-adverse. As I've gotten older, I've gotten more comfortable with more risk, and now I'm quite happy leaving that money in stocks while paying off the loans over their full length. I don't think his plan is currently going to cost him much (assuming they are subsidized loans), but he could have a better plan.