I’ve noticed another weird phenomenon among medical students. It involves a fear of having their interest capitalized. There seems to be this idea that as soon as interest capitalizes, it starts multiplying in the dark like rabbits, cockroaches, and Mogwai who get wet. Whenever you have a vague, irrational fear, it often helps to do the math.

If you have no idea what I’m talking about, I’m talking about interest on interest. Some loans, particularly a number of types of student loans, are simple interest only, or they’re simple interest until you graduate. Simple interest means that the interest doesn’t earn any interest. So you end up with two separate pots of money- the principal and the interest. Interest accumulates on the principal, but not on the interest. When interest “capitalizes” the two pots are combined and it all becomes principal. So now interest accumulates on both the principal and the interest. Interacting with medical students, you would think this was the equivalent of the Titanic hitting an iceberg.

Okay, let’s do the math. We’ll use big round numbers to make it easy. Let’s say you have $200K in loans. In fact, let’s say you take out $50K a year for four years in medical school. They’re all at 5%. Upon graduation, let’s say the interest capitalizes. Then you make no payments in residency for three years. Then, like a good little WCI reader, you pay off all the loans in two years by living like a resident. How much more money do you pay back because the interest capitalized at the end of med school compared to if it didn’t capitalize until the end of residency? Let’s do the math.

Okay, year one, you borrow $50K. The interest by the end of the year is $2500, so you now owe $52,500. In year two, you borrow another $50K. By the end of the year you owe $107,500. In year three, you borrow $50K more- total of $165K. Another $50K as an MS4 and you graduate owing $225K, of which $200K is principal and $25K is interest.

Now, what happens during your intern year if the interest capitalizes versus if it doesn’t. If it doesn’t capitalize, that $200K generates another $10K in interest. If it does capitalize, the $200K generates another $10K plus the interest generates another $1,250 in interest for a total of debt of $235K versus $236,250. Wow! $1,250! You’ll never get out of debt. You’re doomed! Doomed I say! Even if you carry this exercise out throughout the next 3 years, at the end of residency you’ll owe a grand total of something like $5K more because your interest capitalized. How long will it take to pay that off as an attending? Maybe an extra 2-4 weeks if you get busy and pay your loans off right after residency.

So, if you can avoid capitalizing interest that’s great, but don’t bend over backwards to avoid it. Refinancing or going into a repayment program such as RePAYE over PAYE as a resident, or PAYE over RePAYE as an attending going for PSLF will probably make a much larger difference, even if your interest ends up capitalizing sooner than it otherwise would have. When you refinance, you lower the interest rate on the entire debt. So if you owe $250K, and you go from 5% to 3%, that saves you $5K a year. It’s worth capitalizing the little chunk in order to lower the interest rate on the big chunk.

I love Wisconsin.

I love Wisconsin.

The Danger of Refinancing

While we’re at it, I’d like to point out a little known danger of refinancing your student loans or mortgage. Several things happen psychologically when you refinance:

  1. The debt becomes less scary because of the lower interest rate
  2. You feel like you did something
  3. You start looking at other alternatives for your money

Why is any of that a problem? Well, let’s take # 1. When you owe money at 7%, you know it’s growing rapidly. In fact, it’s doubling every 10 years. It’s a big deal. You know you need to do something about it. It’s frequently on your mind and it focuses your attention. But if you can refinance it to 2%, well, now it only doubles every 36 years. That’s not very scary. That’s half a lifetime. You may no longer feel a desperate urge to get rid of it.

Now, consider # 2. When people refinance a debt they feel like they accomplished something. In reality, the debt is exactly the same size. The accomplishment is a bit chimeric and may cause you to sit back on your laurels more than you otherwise would with regards to your debt.

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With # 3, you start looking at other alternatives for your money and perhaps lose critical focus. A 7% guaranteed return looks like a great investment. If it’s only 2% though, well, maybe you should put money in your HSA, and your 401(k), and your Roth IRA, and pay off your mom and dad. That’s all well and good. In fact, that can even be a wise move as borrowing at 2% and earning at 5%+ yokes the power of leverage. Obviously both paying down debt and investing increase your net worth. However, what usually happens is that you not only look at that Roth IRA, but you also look at that Audi, that vacation to Puerto Rico, and that house your spouse wants. Then you, consciously or subconsciously, divert part or all of your funds toward spending rather than building wealth. But even if you are super disciplined and use all of that money to build wealth, you are likely to lose that precious power of focusing on one goal at a time and perhaps even get paralysis by analysis and just leave the money in your checking account where it acquires a magnetic attraction to Teslas.

So what can you do to avoid this issue? Well, it helps to be conscious of it. But perhaps the key is to not change your plans to pay off the debt just because you were able to lower your interest rate. Use the savings from the lower interest rate to pay the debt off even faster than you would have otherwise, rather than getting distracted into investing or spending the money.

What do you think? When did your interest capitalize? How much more did that cost you? Have you refinanced your mortgage or student loans? How did that change your behavior? Comment below!