qmmm I'm also a bit confused by your post. Are you saying we should not pay the interest and instead take the amount we would have paid and place it in an money market account? I got lost around the "earning interest on the interest" for Case (2)
I'm sorry if I was confusing.
In my opinion, having some money on hand in case of emergency is a pretty valuable thing. So instead of making the interest payments, I'll be stashing money into a high interest savings account each month.
Let's see if some numbers help...
Let's say you take out $10,000 in a lump sum @ 6.8% interest where the interest payment, if unpaid, get capitalized each month.
If none of the interest is paid, 36 months after the loan was taken out you would owe @12,255.92. Thus, $2,255.96 is the total amount of interest that accumulated by not making a single interest payment.
The interest payment for the first month would be $56.67. The interest payment for month 36 would be $69.06.
Let's consider what would happen if you save $57.00 each month, for 36 months, in a savings account that gets a 5% return/yr. After 36 months, you will have $2,208.94 in your high interest savings account.
Thus the effective cost for not making the interest payments is $46.98(=$2,255.92-$2,208.94).
Obviously, most people are taking out more than $10k/yr. At some point, it becomes really difficult to make a deposit into your savings account that's large enough to keep up with the interest payment when you're taking out 3 or 4 times as much out in a year.
Anyway, I hope that clarifies things a bit.