How you use a loan determines tax benefit

My friend Kartik had a query about the education loan of around ~1 crore he planned to take to finance his daughter’s overseas education.

I was curious to know why Kartik planned to take an education loan when he could easily pay for her overseas education out of his own pocket. What had attracted Kartik to the idea of taking a loan was that the entire interest paid on an education loan is fully tax deductible, without any limit, under Section 80E of the Income-tax Act. Kartik pays tax at very high rates. Hence, his effective interest cost (after taking tax benefit into account) would be quite economical. He was confident his investments would earn a higher rate of return than the effective cost of the education loan. So Kartik was reluctant to liquidate his investments to pay for the overseas course.

Kartik had no outstanding loans. His annual disposable income was more than sufficient to repay the education loan. His existing residence, which he was providing as collateral security, was thrice the value of the education loan. Given all these facts, his query was why the eight-year education loan costs 9 per cent per annum whereas a 20-year home loan from the same bank is available at less than 7 per cent per annum.

Kartik had raised an important point. I explained to him how, in most cases, education loans are riskier than home loans. The income of parents who stand as guarantors is rarely sufficient to pay off the loan. In such cases, the repayment depends on the student’s earnings after finishing the course. If they are not sufficient, or the student drops out of the course, the repayment suffers. The value of the security provided is rarely much higher than the loan amount in many cases. That makes an education loan riskier, as is evident from the high default rates on them.

But none of these factors held true in Kartik’s case. I suggested that he should take a loan against property from the same bank, which is available at around 7.5 per cent. This way he could reduce the cost of the education loan from 9 per cent to 7.5 per cent. Kartik decided to act on my suggestion.

Kartik then informed me that while the bank was willing to provide a loan against property at 7.5 per cent, the interest payable on loan against property would not be tax deductible under Section 80E. I told him that interest paid to the bank on a loan against property would also be tax deductible if he could prove that the loan was utilised for his daughter’s higher education. Nowhere in Section 80E is it mentioned that the loan must be titled “education loan” for the deduction to be available. It is sufficient if the taxpayer can show that the loan was used for his child’s higher education. I informed Kartik that many of our clients have availed of low-cost loans against their mutual funds to fund their children’s higher education and availed of Section 80E deduction.

The same principle applies to home loans as well. If a loan is used to acquire or construct a house, the interest on it is deductible even if the loan is an unsecured loan or a loan against a security. It need not be called a home loan for the interest to be deductible.

Truth be told, the Bard was right when he said, “A rose by any other name would smell as sweet.”

Interest paid on even a loan against property is tax deductible if you can prove that the loan was utilised for your child’s higher education