A client’s daughter was planning to go abroad for education. Their friend suggested that they should consider an education loan as the net of tax cost would be lower than the return that they can expect on their investments in equity shares and equity mutual funds. The interest rate on a home loan is around 10.5% and with a tax rate of 35%, the after tax rate will be around 6.82% much lower than the 10%+ that can be earned from investments in shares.
The above did not consider the loan processing fees that one ends up paying and another upfront cost of almost a lakh for being forced to buy a group life cover on the life of the daughter who at that point in time was not earning and had no need for insurance. The real need is for the parent but that is not the topic for discussion today.
The loan disbursement was taken and the EMIs started. Since the education was not completed, the EMIs took care solely of the interest component. At the end of the year, when the tax computation was done, it was determined that the tax under the new regime was lower than that in the old regime even after considering the interest on the loan. In addition, the equity markets have given either negative returns or low single digit returns depending on whether you are looking at the Nifty 50 or Nifty 500 returns.
Since there was no tax benefit due to the loan, the cost of the loan stays at 10.5% and does not reduce as there is no reduction in tax liability due to the loan. Are there any scenarios where taking the loan can get a tax benefit and hence a reduction in the effective interest cost?
We did the math. We assumed that the cost of an education abroad can be Rs 75 lakhs per annum and we also assumed that a person who is earning 75 lakhs per annum is taking this loan. The tax savings in the new regime compared to the old regime is Rs 4.8 lakhs per annum ( assuming no standard deduction and other deductions in both regimes). The interest cost per annum is Rs 7.87 lakhs and the tax savings on this interest cost is Rs 2.7 lakhs. So one is giving up a benefit of Rs 4.8 lakhs and the net loss is Rs 2.1 lakhs. This makes the cost of the loan at 13.3%. Now your investments need to make much more than 14% per annum on an average over the next 6-7 years for the loan to prove beneficial. However, 13.3% is a high cost and it may be challenging to get a higher annual average return over the next 6-7 years unless higher risk is taken.
How does the equation change if the loan increases to Rs 1.5 crs assuming a two year post graduate degree? The interest cost on this loan is Rs 15.75 lakhs and the tax savings on this amount is Rs 5.41 lakhs whereas the amount of tax foregone due to regime change is Rs 4.8 lakhs per annum. Therefore, there is a tax benefit in this case of Rs 0.6 lakhs and the effective interest rate become 10.1%. An annual return of 13-14% per annum may justify the cost but the cushion is not very large. As the loan amount increases, the after tax interest cost will decrease.
Therefore, one needs to consider the tax benefit foregone while moving from the new tax regime to the old tax regime while determining the true cost of the education loan. A loan amount of greater than Rs 45 lakhs will make you tax neutral between the two regimes and hence the interest cost will be the interest rate on the loan. Only once the loan amount increases, will the effective interest rate cost start decreasing. So do consider the tax benefit foregone while computing the effective interest cost on the education loan.
The worst case scenario is that the interest cost stays at 10.5% since there is no tax subsidy on the same. Hence, if you want to use the same as leverage then the asset allocation needs to take on more risk to get a higher return. If the tax break is available due to a higher loan amount, then the risk taken could be lower since the effective interest cost would be lower than the rate mentioned in the loan agreement.
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EquiZen, a registered mutual fund, SIF (ARN-272487 – Sanjay Parikh) and PMS distributor (APRN-00158), offers personalised financial solutions with a focus on safety and transparency. We aim to assist you to achieve financial freedom, the freedom to do what you want and achieve your dreams. We do not push financial products but believe in utilising them judiciously to meet your needs. Learn more at www.equizen.in or contact us via +91 9820605203 or sanjay@equizen.in.
