Daniel Barkowitz | August 15, 2006
"Congratulations, you've just won $1,000,000..."
Imagine the following scenario:
The doorbell rings and it's the Publication Sweepstakes with a bunch of prize balloons and the news that you are a $1,000,000 prize winner. The cameras flash, the microphone is stuck into your face for your witty "Oh, My God", and they hand you a fake 3' by 2' check replica.
But now for the hard part. How do you want your winnings?
Your options follow:
1. $50,000 per year for the next 20 years; or
2. An upfront cash payment for $600,000.
Which is the better deal? (Vote here, and then click below to read the rest of the entry for my answer...)
Now for the answer, and my rationale. First of all, I calculated that the better option is the $50,000 per year over the next 20 years, but it is close. Here are my assumptions: I assumed that 1) you could find a comparable investment rate of 6% annually, so your lost opportunity cost (or interest rate, if you will) is 6%; 2) you would pay a 33% Federal tax to the IRS for the upfront payment, and a 25% Federal Tax per year under annual scenario. The answers I came up with (see here for the data) are $421,427 in today's dollars under scenario #1, and $402,000 under scenario #2.
So why the bother? Many of you will be taking out student loans in the next several months, and some of your parents will be using parental loans to finance your educational costs at MIT, but many times I see students who are total math wizzes who forget that the "time value of money" formula applies to student and parent loans.
While I am certainly not suggesting that you need to do a spreadsheet for every loan you have (although Quicken and other software products will do this for you), I do think it is important to remember how deferment and other choices you make can affect your loan. For example, if you look at MEFA's web page, you will notice that the MEFA Undergraduate Loan has two different payment options: one for immediate repayment at a fixed interest rate of 6.49% and one with a deferred payment option with a rate of 6.99%. You might look at this and think, well I will choose the immediate payment since the cost is less (and most times I would agree with you). But for students who are going to defer their balance during all four years of education, the APR is actually lower under the deferred plan (6.95% vs. 7.09%).
Why is this? It's all about the time value of money. The $1 you pay back today is worth more than the $1 you pay back 4 years from now, so even though the interest rate is higher, it's the APR you need to pay careful attention to.
So, how did you do on the survey? Any flaws in my model?
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The author has filed this entry in the "Financial Aid" section; check it out for further reading on this topic. |
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ahh...coolest entry...fun to see how finance works!
Posted by: Arka'10 on August 16, 2006 02:46 AM
Of course, you're neglecting the idea that $400,000 invested now could generate a large sum of money in the future. If investment is thrown in the picture, which option you choose to take depends almost entirely on how good you are at a) spending money quickly or b) investing money wisely.
Posted by: c21 on August 17, 2006 01:30 AM
How old is the recipient? Does he have heirs? He might want to consult mortality charts and calculate the odds of whether he's going to be around to collect the last payments. If he's over 55, that lump sum payment might make more sense.
Posted by: jazmaan on August 21, 2006 01:15 PM
Thanks for the comments. c21, I was sort of taking the lost opportunity cost into account with the discount rate of 6% per annum, but I do get your point! And jazmann, too funny -- I guess that would come into play!
Posted by: Daniel Barkowitz on August 21, 2006 01:21 PM
