How to Make Sense of the Indian Economy: Car Loan Interest Rate Primer

Having examined how Savings and Fixed Deposits work, I will now move to some common consumer lending products.

 

Lending or Loan products enable you to borrow funds from the bank and in turn make you liable to pay back interest along with the principal. Loans can serve various purposes: to buy a car (Car Loan), to fund a house or property purchase (Home Loan), to pay for college tuition fees (Education Loan), or to pay for an expensive wedding (Personal Loan) etc.

 

This week’s edition will focus on the ubiquitous Car Loan.

 

What?

 

The Car Loan is a consumer lending product which can help you fund your car purchase. It is a type of Secured loan which treats the to-be-purchased car as a collateral, meaning the bank has the right to repossess your vehicle if you default.

 

How?

 

Banks and Non-Banking Financial Companies (or “NBFCs”) advance Car Loans covering a part or whole of the to-be-purchased vehicle’s ex-showroom price (or the latest fair value in case of a used car). Any remainder amount would come from the car buyer's own pocket i.e. down-payment. These loans can be structured to be repaid over a duration (in India atleast) of 1 to 7 years (“loan period”) via Equated Monthly Installments (EMI).

 

An EMI plan essentially spreads the total principal & interest due equally over the loan period and is chargeable on a monthly-basis.

 

Explaining EMI

 

Your EMI plan would depend on:

 

Though it is an interesting exercise to see how an EMI is calculated, we will not get into that here. For that you would need to be familiar with certain concepts such as the Time Value of Money, to be covered later in this series.

 

Think of EMIs as future cash flows which when “discounted” would be equal to the outstanding loan amount as of today (or the “Present Value”).

 

There are various free EMI calculators available online which you can use to confirm what the bank is quoting. Otherwise simply open an Excel file and use the =PMT() function to do a quick calculation.

 

What Interest Rate?

 

The applicable interest rate driving EMI is set by the bank and for Car Loans it is usually “Fixed” in nature i.e. it does not change through the loan period. The quoted value would depend on:

  1. Your existing credit score – preferred to be above 750
  2. Your monthly salary
  3. Your debt to income ratio – preferred to be below 50%
  4. Quality of the vehicle – new cars attract a lower interest rate as the bank will be able to resell it more easily and recover more money in case of a default
  5. Your down-payment – a higher down-payment means the bank’s risk is reduced and hence would lead to a lower interest rate

 

You can check an online loan marketplace to get a sense of applicable interest rates. They are usually expressed on an annualized basis and are advertised rates. 

 

Floating Interest Rate

 

Some credit institutions (mostly NBFCs) may offer a “Floating” interest rate. This rate is usually structured as:

 

1-year MCLR + Spread

 

In layman terms, MCLR or “Marginal Cost of Funds Based Lending Rate” is the minimum allowed interest rate below which a scheduled commercial bank or NBFC is not allowed to lend. It is set by the Reserve Bank of India (RBI) and are driven by short-term interest rates set by the Monetary Policy Committee (MPC). The additional Spread includes the lending banks’ margin and the customer’s risk premium.

 

Floating interest rate, as the name suggests is not constant. It “floats” during the loan period depending on RBI’s monetary policy actions.

 

When RBI's short-term interest rates go up > the MCLR goes up > hence the Floating interest rates on Car Loans go up, and vice versa.

 

Floating interest rates ensure that borrowers can benefit from any future rate reductions by the RBI after they have already taken the loan. It also means you will get hurt when RBI’s rates are going up.

How to Make Sense of the Indian Economy: Car Loan Interest Rate Primer 

Other Charges?

 

Processing Fees: The bank would charge a processing fee (structured as a fixed amount or as a percentage of notional – sometimes waivered during negotiations). This fee would not be netted off the loan amount but is charged as an add-on.

 

Prepayment Charge: The bank does not want you to prepay your principal before the loan period ends as it will lose the interest income it makes (again the bank is conscious of the power of compounding). Hence, they typically charge a prepayment charge (i.e. if they allow prepayment or pre-closure) as a percentage of loan amount when you end up prepaying. It is ironic as you will be charged for paying back before time.

 

Loan Cancellation: There are loan cancellation fees, usually a fixed amount per cancellation.

 

Documentation Charges: The bank will charge for any documentation it needs to administer e.g. for obtaining No Objection Certificates, preparing statement of account, for the CIBIL report, amortization schedule etc. They are not very significant.

 

Late Payment Charge: Late payments are penalized through a Late Payment Charge as a percentage per month on the outstanding installment. Even with the charge, a late payment must be avoided to maintain a good credit score.

 

Things to Watch Out

 

  1. Shorter is the loan period > lower is the credit risk faced by the bank > hence lower would be the interest rate applicable
  2. A new car will attract a lower interest rate vs. a used car
  3. A higher down-payment from you means > a lower credit risk faced by the bank > hence lower would be the interest rate applicable
  4. A fixed interest rate helps you plan your finances better as you will have a sense of your dues upfront. If RBI pushes downs short-term rates in the future, you will not benefit. If RBI increases short-term rates in the future, you will benefit
  5. A floating interest rate ensures you benefit when RBI pushes down short-term rates. It also means you will get hurt when RBI’s rates are going up. Fixed rates would always be slightly higher than the corresponding floating rates.
  6. Do the math around whether you save any money if you’re prepaying your outstanding loan amount. If you prepay close to your loan period end, you may end up paying more via prepayment charges.
  7. Evaluate the option of car ‘lease’ instead of a Car Loan
  8. There are separate schemes for Women drivers, do ask your bank
  9. Some banks ask for a Guarantor, most banks don’t
  10. Car Loans availed by individual customers do not offer any tax benefits. Car Loans availed by companies are eligible for tax deduction under Section 80C of the income tax act

 

Next week we will do a similar exercise to better understand Home Loans

 

This will be a recurring column published every Friday under the title: “How to Make Sense of the Indian Economy”.

 

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