Must-knows about education loans

New Delhi: You can use ULIPs and Mutual Funds, PPF and gold as investment tools for your child’s education. But let's not look at education loans as a means of funding the same. There is fierce competition to finance just about every activity of your life – be it buying a house, planning a vacation, lifestyle related expenses, insurance or your child’s education.

Though these options may seem viable, you should not lose sight of the fact that these are all a part of the ‘Great Indian Debt Trap’ where you end up committing your future earning towards your expenses every month.

The good part is that it helps you in funding your child’s education expenses because you did not plan saving for their education appropriately at the right time. Nevertheless the bottom-line is good education for your child.

Here are some options:

Unit Linked Insurance Plans: Almost all insurance companies in India offer one or more options to plan your child’s education. The question is: what should you buy and what should you be careful of, while selecting the plan.

• a. Administrative charges: These are charges deducted from your contribution towards sales/ advisors/ agent commissions, administrative and other fixed costs to be covered to serve the policy throughout the policy term. The best way to find the total charges on a policy is to calculate a future value. If you invest over a period of time, use the projected rate of per cent and deduct the maturity amount given in the illustration provided by the company from it. The difference is the total charges deducted by the company for the policy. Make sure your rate of calculation and the company's projected rate of growth are the same.
• b. Annual fund management charges: Every company offers a basket of funds. Based on this, the fund management fees will vary. Remember, a lower fee does not mean a better product; a higher fee guarantee also does not guarantee a better performance. Typically, a fund that requires active management will have higher fees, while funds that are predominantly bond or liquid funds will have lower charges.
• c. Switching cost: The basic rule of investment: book your profit from time to time. When markets are bullish, you need to book your profit by switching returns on your investment to funds, which are primarily for capital conservation. PAGE_BREAKThis requires you to switch your funds from one fund to other; hence, there should be a sufficient number of switches permissible in a given year. Ideally, four switches per year should suffice.
• d. Insurance cover: Ideally, if you opt for an education plan and do not have sufficient life cover, you should take one equivalent to your child’s projected education expenses. The life insured has to be of the father/ mother, ie, the bread earner. It is not a wise idea to take an insurance cover for your child.
• e. Waiver of contribution: This is an important rider. In the eventuality of death or disability of the life insured, future contributions are waived. The percentage of people who actually claim this might be small, but you never know what will happen in future.
• f. Family income rider: This is another feature you should consider while taking a ULIP plan. This rider comes into the picture when a constant income is provided to the family in the absence of the breadwinner to provide for the child’s expenses till major payouts happen in the plan.

2 Mutual Funds: A few houses do offer funds for a child’s education. But when compared to their structured counterparts offered by the insurance companies, they may not sound very attractive.

Investing in mutual funds is a good idea for your child’s education, provided you have a sound, professional investment advisor who monitors your portfolio till the maturity proceeds.

You could also consider diversifying your investments across various asset classes, because over-exposure to equity would increase the risk on your investment.

Wherever you do invest, I would advise you to start investing today, irrespective of market levels, rather than wait for markets to crash. If your horizon is five-years plus, invest a constant amount every month, and try to increase your contributions when markets go into correction mode. This strategy will never go wrong for a mid-term or a long-term investor.

There are many other options available for investment to fund your child’s education.

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But let's pause and look at the flip side. Here are some points to ponder before you think of education loans.

Interest Rate Risk:

Education loans are available with two options: Fixed Rate of Interest and Floating Rate of Interest. Most banks offer the floating rate option only.

Floating rate has revision cycles which differ from bank to bank. It can be a monthly, quarterly, half yearly or yearly reset option. When interest rates move higher you end up paying a higher amount of EMI, or else, the tenure of your loan gets extended.

Consider a few important points, and how these will affect you before you take an education loan:

1. When will the interest rate change?

Interest rates will changes at a fixed period of time and this is referred to, as the Review Date, and is specified when you sign the loan agreement. Typically, it happens every quarter or monthly.

2. How will the interest rate change?

Interest rate offered to you is based on a base rate. The bank will have a base rate which is the lender's pre-selected internal rate. The base rate changes due to changes in the interest rates in the economy.

If interest rates in the economy rise, the base rate will rise. If interest rates in the economy fall, the base rate will drop. Different banks adopt different nomenclature to coin a word for this base rate.

3. By how much will the interest rate change?

You need to understand the technical aspect of this. There is a spread or margin on this base rate. The spread/ margin is the percentage added or subtracted from the base rate. This is meant to cover the lender's administrative and other costs.

To the base rate, the bank will attach what is called a Spread.

Eg: Bank’s RPLR = 10.00%.

The interest rate offered to you for education loan is = RPLR - 1% = 9.00% it can also be It could also be = RPLR + 0.5%. = 10.50%

Depending on various factors, the bank will decide on the interest rate and if it is higher (premium) or lower (discount) than the base rate.

4. How will it affect me?

When you take an education loan with a floating rate, you have two options.

Option 1: The rate of interest increases or decreases, but you keep the tenure constant. In that case, the number of years you take to repay the loan stays constant but the EMI increases or decreases.

Option 2: When the rate of interest increases, you can extend the tenure. In that case, the number of years you take to repay the loan increases but the EMI stays constant. Similarly, when the rate of interest decreases, you can reduce the tenure of your loan.

This is a very important factor which can lead your educational loan repayment plans haywire if interest rates shoot up.

Parents normally opt for education loans when they are in the 40-50 age bracket. Due to this higher age bracket, the loans are provided against a higher collateral like house, deposits or stocks.

Education loans have an initial moratorium till the child secures a job. Some offer the facility to start repayment after a certain pre-specified period from the completion of the course.

The author is a wealth management specialist with an MNC bank in Dubai.