Not all interest rates are created equal

Ever since I started working on GyanDhan, one of the top questions I get asked is ‘How can you compete with XYZ player in the US/Europe when they offer a much cheaper loan?’. Depending on the situation, I then go on a discourse on how it is not correct to compare interest rates in 2 different currencies. Recently, I had a long conversation with a friend from B-school on the same topic, and that is when I realized that even folks with financial education completely miss the point on interest rates.

Before starting a theoretical discussion, let us look at some actual historical numbers.

It is Apr’08. You have received an admit from the college of your dreams. You are now looking for financing options to realize your dreams. The amount required is $50k or c.21 lakhs rupees based on the prevailing exchange rate of 42.2, and you are looking for a 7 year loan with the standard 24-month moratorium period where you do not make any payments during your period of study. You have been approved by 2 institutions

1.) An Indian bank is willing to provide you a rupee loan at 12.5%,

2.) A US-based institution is willing to provide you a dollar loan at 7%.

There are a couple of assumptions in the following exercise. We have assumed that

a.) The interest rates stay at the same level for the lifetime of the loans. Pre-payments, and late repayments are not considered in the analysis below.

b.) Both institutions have the same offer on all other parameters like processing fees, loan term, and other loan requirements.

c.) Exchange rates as of month-end are considered for all calculations.

Considering that there are no other costs to consider you might be tempted to believe that the second offer is much better. What actually transpired is a much different story altogether.

Expected monthly payments for a student loan

Had you taken the Indian loan, you would have been expected to pay nearly 47,000 on a monthly basis for the next 7 years. You would have paid nearly 40 lakh over the lifetime of the loan, this included an increase in the loan amount from the initial 21 lakh to 22.5 lakh. The red line in the figure above shows your expected payments from the Indian loan.

On the other hand, if you chose the US loan you would have expected to pay $827 starting May’10 which would be a mere 35,000 on a monthly basis based on the exchange rate at the time you took the loan. However, what happened during the period May’08 — Apr’16 was that the USD-INR exchange rate rose from 42 to 67.
As you can see in the chart above, almost 2 years into your repayment period the US loan actually ended up being costlier on a monthly basis than the Indian loan.

Over the lifetime of the loan, you would have ended up paying more if you took the USD loan. We have not considered that the Indian laws allow for a tax deduction if you have taken an education loan from an Indian bank but not if the loan was from an overseas entity. I had an MBA loan from overseas and this comes from personal experience. Looking at an NPV based approach might make the foreign loan look even more horrendous.

I will write another blog sometime later explaining the theoretical underpinnings of this, but it is safe to say that currency depreciation is linked closely to interest rate differentials and they are not independent of each other on a longer time horizon.

Which rate is better for you then?
Are you 100% sure you will end up working in the country where you are planning to study (say US)? If yes, a $ loan might not be a bad option as you would not be subject to any currency fluctuations. Be aware though that headline rates do not tell the entire picture, a 7% $ loan might turn out to be costlier than a 12.5% rupee loan. If you have a relative or someone who is willing to act as a co-signor in the US, and provided that person has a good credit history, you should try to get a $ based loan as the nominal interest rate might be really low.
If you think that there is a possibility that you might return to your parent country after completion of your studies, you don’t want to run the risk that some of my seniors, who were taking up jobs in India, experienced back in 2014 when they realized that their Euro loans had increased by c.25% due to fluctuations in currency.

At GyanDhan, we are working currently with Indian lending partners to provide education loans to help you realize your dream. Going forward, we have plans to help you access other financing options (US/Euro) if you so choose. Our recommendation even then would be to not blindly look at sticker rates but make a prudent choice when it comes to taking loans.