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?