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How loan deferment works

What does it mean to defer payment on a student loan? Take a closer look at what's really happening while those loans are in deferment, when it happens, and what it all means for you.

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When you borrow money or take out a loan, there is one of two situations. There's one situation where you need to pay interest immediately, so let me write that as pay interest immediately; and then there's another situation where you are allowed to defer the interest over some period of time. And even in those situations where you are allowed to defer the interest, there is some situations where it is subsidized – essentially someone is making your interest payments for you during that deferral period – and then there is other situations where it is unsubsidized.  

Now in the world of student loans, we typically think most student loans fall into the category of deferred interest because whoever is lending to you, whether it's the government or oftentimes even a private bank, they understand that while you are in school, you do not have a job, and so you are unlikely to be able to make payments. This tends to be the case for student loans, and the period of deferment tends to be while you are a student because they recognize that you are still in school, and sometimes there is a grace period after that, and then there is sometimes even a potential for deferment of interest payments if you're going through some type of hardship, if you are on unemployment or whatever else. But there's typically at minimum a deferment while you are a student, and there's different thresholds depending on the loan that you're looking at on how much of a student you have to be. Do you have to be fulltime, do you have to be part time, or whatever else it might be.

But to understand how deferment works and what subsidized versus unsubsidized would look like, I'll use an example. So the typical example for a subsidized loan – and a subsidized loan will, at least in all the cases I can think of, will almost explicitly come from the government, so these come from the government, from the Department of Education, and these tend to be for students who qualify for financial aid, especially at the undergraduate level.  

So let's look at the example of a subsidized loan, and as the example, I will use the direct – Direct Subsidized Loan from the federal government – so what we call the Direct Subsidized Loan. And then just to compare it, we will also look at an unsubsidized loan, and maybe I don't have to keep writing this word, subsidized, we'll look at the Direct Unsubsidized Loan. And once again, you get this. This is at the undergraduate level if you qualify for financial aid. This could be more general than just that. It could happen for, well, I won't go into all of them. The whole point here is to understand the impact of being able to have a subsidy on your deferred interest over some period of time.

So let's say that in your freshman year, when you have to pay that first round of tuition, let's compare the difference between taking a Direct Subsidized Loan of $1,000 – and once again, not everyone qualifies this but this is just to give a sense of what happens to the interest over while you are deferring it – versus taking $1,000 of Direct Unsubsidized Loan.  Now let's say in either case, you are allowed to defer to it over the period that you are a student, and let's say that happens over the next 4 years. There tends to be some maximum cap on how long you can defer it, and they tend to be a little bit longer than four years. For things like Subsidized and Unsubsidized Loans, we're looking at 6 years, but you should obviously look at the special cases and these things change, so you should definitely look at the specifics to whatever you are borrowing.

Just remember, this is just for that first period. You're going to probably keep borrowing.  Probably the second semester you'll borrow some more, the next year you're going to borrow some more, but let's just say that first disbursement that you get, you defer it in either case until you graduate, and let's not even think about the grace period, let's just think about what you owe after 4 years. So this is 4 years goes by in either situation, 4 years go by.

Now in the Direct Subsidized Loan, you don't have to pay it for 4 years, and you don't have to pay the interest on it for 4 years, and the interest is essentially being subsidized, it's being paid for by the federal government. So after the deferral period, how much do you owe? You still owe $1,000. Now, what happens on the Direct Unsubsidized Loan? Well here, you don't have to pay the loan down or you don't have to pay the interest for 4 years, but that interest is accumulating and it is compounding. It is being added to what you actually owe.  

So let's say in either case, the interest – and once again, it's going to be different depending on when you actually get your loan – let's say in either case, we're looking at a 4.66% annual interest rate, so if we accumulate at a 4.66% annual interest, how much are we going to have to owe at the end of 4 years in this situation? To answer that question, we can do a little bit of mathematics.

So if you have 4.66% per year, if you want the daily compounding rate, because these things compound on a daily basis, so 0.0466 – and once again, you should check what your interest rate actually is. I'm just using this as an example – and then we take the mathematical average of the number of the days you have in a year. If you average out the leap years and the regular years you get 365.25 days in a year. So you have 1.27583 so on and so forth, times 10 to the negative 4, which is the same thing as 0.00012758 and you could go on and on.  

I had to keep pausing this video while I sneezed. I didn't want you to have to deal with the sound of that. Anyway, where was I? So this is the same thing as 0.00127 on and on and on per day. This is your daily compounding. So over 4 years, how many days are there?  Well, it's going to be 365.25 times 4.

So essentially how much are you going to have to pay? How much is going to be the capital that you're going to owe, or the principal I guess you should say? So $1,000 times – now, you are going to compound by 1 plus this amount, so I'm just going to do second and answer, so that means my previous answer. So 1 plus that amount is how much you're compounding per day, and how many days are there over four years? So it’s going to be 4 years times 365.25 days per year.  

So once again, this is the number of days in 4 years, so it's going to be over 1,000 days, over 1,200 days, actually over – well, you get the idea. It's over that many days, and you're compounding this much each day, so you're essentially multiplying this number that many times, times 1,000, and so this is going to give us how much we're going to owe with that interest. We didn't have to pay it, it's being deferred because we're students, we can't pay it right now, but how much are we going to owe after the deferment period? So it's going to be $1,204.88, or if we round, 89 cents. So we are going to owe $1,204.89 if you round up.

So hopefully, this can give you a little bit of appreciation for how powerful this part right over here is. Over here, we're owing over 20% more deferring over those 4 years, and this is just for $1,000 – it's going to be 20% regardless of this amount right over here but this for our first loan. Now when we take a loan in junior year, you're going to be deferring it for less time so you're going to accumulate less interest, but it's giving you the value of what this subsidy is at least for that first $1,000 that you are deferring for 4 years. You're saving over $200 of interest by getting the subsidized loan. Now once again, not everyone can get the subsidized loan but if you can, hopefully you'll appreciate its value right over here.

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