Self-Financing vs. Education Loan

You are planning to go for higher education. You got the admit letter from your favorite college. Everything is going smoothly. There is just one dilemma, whether you should finance the education from own funds or take an education loan. In this post, let’s look at some of the aspects that can help you make a decision in such cases. Clearly, this comparison is meaningful for those who have an option to finance on their own. If you don’t have the money, you have to go for a loan.

1. Tax Benefits

You do not get any tax benefits for paying the college education fees from your pocket.

In case of education loan, you get tax benefits for interest payment under Section 80E of the Income Tax Act. There is no tax benefit on principal repayment. You can read about tax benefits of education loan repayment in great detail in this post. These tax benefits bring down effective cost of loan.

2. You Do Not Need All the Funds at the Same Time

Typically, you do not have to pay the entire college education fee upfront. The college or university asks for it in tranches, say before the beginning of trimester, semester or year.

If you are financing on own, you need to keep this amount in liquid investments since the funds will be needed in short terms. This automatically brings down return expectations. However, at the same time, since you are not earning, you may have to pay very low tax rate on interest income or capital gains.

With an education loan, you can withdraw as and when you need it. Remember you pay interest only on the disbursed amount (and not on the sanctioned amount). There may be commitment fee (on the sanctioned amount in a few cases).

3. Moratorium Adds to the Loan Amount

It is difficult for you to repay the education loan while you are still studying. Even though you are not required to pay anything during the course of your education and an additional 6-12 months after your education gets over, this does not come free. Banks never give anything for free. Banks merely add to the interest to the principal amount. Power of compounding in reverse in full flow.

4. Flexibility with Expenses

Expense for college education is not just about paying the tuition fees. There could be host of ancillary expenses. For instance, mess charges, expenses for various education trips, purchase of books and laptops and general living expenses can add up to a big amount. If you are going overseas for education, cost may shoot up dramatically (or you may have under-estimated the cost). Or sudden sharp inflation may mess up your entire planning. Education loans may have this buffer (perhaps not for inflation) built in.

However, if you are planning to finance on your own (or your parents are doing it for you), you need to keep this aspect in mind.

5. You Can Invest Your Savings and Earn Better Returns and Take out an Education Loan

The argument goes like this. Even if you can finance education on your own, you can invest your savings (rather than use it to pay education fees) and earn better returns. To finance education, you take an education loan. It needs to be noted that education loan gets you tax benefits. Therefore, effective cost of loan can be much lower. If you fall in 30% tax bracket and interest for education loan is 10% p.a., the effective cost of your loan is only ~7% p.a. All you need to ensure is that your investments earn a better post-tax return.

Personally, I do not buy this argument. We are comparing apples and oranges. The returns that you earn are not guaranteed while you must pay the education loan on time. Therefore, we are comparing different risk return profiles. Do note that non-payment of interest during the moratorium period adds to the loan size.

But, if you (or your parents) have to dip into your emergency funds (retirement funds for your parents) to fund education, it is a better idea to opt for an education loan.

6. Flexibility after Completing Education

Not everyone ends up with a good job after college. A few may move out of the campus without any offer. An education loan can put stress on your cash flows. You can always argue, that since this post is about self financing vs. education loan, you can always use own funds to repay the loan if you are under stress. Not convincing. In that case, the entire purpose of taking an education loan is defeated. Moreover, that money (own funds) may have gotten used elsewhere. This happens with all of us. We tend to spend more freely when we have money in our bank accounts or funds that can be accessed easily. Or you invested quite aggressively and lost quite a bit of it.

7. Ease

Self-financing scores heavily on this front.

With education loans, you need to find the best deal, complete documentation, provide security or find a guarantor and put up with idiosyncrasies of the bank. If you are not going to Ivy league or premier college, be ready to run around a bit. Whole lot of hassles to deal with.

My Opinion

I believe in keeping things simple. Do not fall for the tax benefits and try to be over-smart. You should not take a loan merely for tax benefits. If you have money to fund education yourself, do it from own funds.

If your parents are funding your education, you need to ensure they are not squeezing their finances to fund your education. Ask them about the source of funds. Parents don’t even mind liquidating their provident funds (meant for retirement) to fund your education. If that’s the case, take an education loan instead.

If you feel you may be able to only part finance the education yourself, take the loan only for the excess amount.

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