Understanding the Higher Interest Rates on Education Loans Compared to Home and Vehicle Loans
Contrary to the perception that interest on education loans is lower than that of home or vehicle loans, it is often higher due to several underlying factors. This blog post explains why and aims to clarify common misconceptions.
Compounding vs Simple Interest
Let#39;s start by demystifying the concept of compound vs simple interest. With home or vehicle loans, interest is compounded on a quarterly basis. Simply put, you end up paying interest on interest, leading to higher accumulated interest over time.
On the other hand, education loans are calculated using simple interest. This means that interest is only applied to the principal amount disbursed and not on any previously accrued interest. However, upon the completion of the educational tenure, the entire accumulated interest is added to the principal amount, and the EMI (Equated Monthly Instalment) is recalculated accordingly.
Importantly, if you service the interest during the moratorium period, your total EMI charge will still apply to the principal amount only – a significant benefit. For those who prove their eligibility, they can even receive an interest subsidy or rebate. For more detailed insights, check out my article titled How to Get an Education Loan for comprehensive guidance.
Risk Assessment and Interest Rates
The key factor determining the interest rate for any loan is the Risk Weightage Asset (RWA). Home loans enjoy a relatively lower RWA because the property serves as collateral. This makes the risk to the bank significantly lower, hence the lower interest rates.
In contrast, education loans are unsecured, meaning there is no collateral to cover the risk. The gestation period or the time taken to repay an education loan is often longer, increasing the risk for the lending institution. This higher risk is reflected in higher interest rates. A typical education loan, particularly those up to ?4.00 lacs, often carries no security, with the account being covered by an NCGTC (Nirvidya Group of Companies) guarantee.
Interestingly, if you are a woman, you can avail an additional interest rebate of 1% if you service the interest during the moratorium period, while a specific benefit of 0.5% is available for women beneficiaries.
These factors contribute to the impression that education loan interest rates might be higher than those of home loans. However, it is crucial to consider that these rates are reflective of the higher risk for the lender, not an absolute comparison.
Loan Segments and Risk Classification
Educational loans are generally classified under personal loans and fall under non-priority in nature. Banks are more cautious while approving these loans, although they have now been recognized as priority sector loans within the personal loan category. Home loans, meanwhile, are recognized as personal sector loans and are classified under the government's priority sector, which entitles them to special interest rates to support infrastructure development.
Education loans are predominantly unsecured, whereas home loans are secured against the mortgaged property. These differences highlight why home loans are perceived as more secure and long-term investment opportunities, resulting in a lower risk and thus, lower interest rates.
The high rate of delinquency among educational loans further reinforces their higher risk category. This contrast between the two types of loans underscores why the interest rates on education loans are often higher.
Conclusion
While it might seem that education loans carry lower interest rates, the nuanced factors of risk, compounding, and security come into play. Understanding these factors can help alleviate misconceptions and inform better financial decisions. If you need more detailed guidance on obtaining an education loan, my previous blog post How to Get an Education Loan is an excellent starting point.