A car is an expensive purchase, and many families take a car loan to purchase the car. In this post, I discuss aspects that you must keep in mind while taking a car loan.
#1 Processing Fee
Car loans are short to medium term loans. Usually, 3 to 5 years. Hence, the impact of processing fee is spread over a shorter tenure. Thus, a high processing fee can easily increase the overall cost of the car. GST is also applicable on the processing fee.
Let’s understand this with the help of an example.
- Loan Amount = Rs 5 lacs
- Loan Tenure = 3 years
- Interest rate = 9% p.a.
- EMI = Rs 15,899
Nil Processing fee.
Effective cost of Loan = 9% p.a.
Processing fee: 2% + GST = Rs 10,000 + 18% GST = Rs 11,800
Effective cost of Loan = 10.64% p.a.
This is a sharp increase in the cost of loan. And shorter the loan tenure, sharper the increase.
If the loan tenure were 5 years, the effective cost would have gone up from 9% p.a. to 10.03% p.a.
How could you be tricked? If you are merely focusing on the interest rate and ignore the processing fee, you could make a wrong choice.
Let’s consider this example.
- Lender A offers a car loan at 10% p.a. and NIL processing fee.
- Lender B offers a car loan at 9% p.a. and 2% processing fee.
You go with Lender B. Later, when you do the math, you would find that the actual cost of loan is 10.64% p.a. You would have been better off with a loan from Lender A.
Therefore, while enquiring about car loans, do not just ask and compare interest rates. You must find out the processing fee or any other charges in the loan. Calculate the all-in cost.
#2 Fixed or Floating
In a fixed rate loan, the interest rate remains constant during the entire loan tenure. In a floating rate loan, the interest rate can change with changes in the underlying benchmark.
From what I have seen, private banks tend to offer fixed rate car loans. Public sector banks (SBI is an exception) tend to offer floating rate car loans.
In an ideal world where you knew about the trajectory the interest rates would take, you would take a fixed rate loan if the interest rates were about to rise. And go with a floating rate loan if the interest rates were about to fall. But it is not easy to predict how interest rates would move. Hence, this makes the choice tricky.
Car loans are short to medium term loans. Therefore, unless you have strong conviction about which way interest rates are headed, just compare the current rates (along with all in cost) and go with a lower cost loan.
#3 Prepayment Charges
Floating rate loans cannot have prepayment charges. And that is due to a regulatory diktat. Fixed rate loans can have prepayment charges. In fact, prepayment charges on fixed rate loans can be quite hefty going up to as much as 4-5% of the outstanding loan amount. A few banks may waive off the prepayment charges after 2-3 years.
Therefore, if you plan to prepay your car loan, a floating rate loan may be a better choice. Or choose a fixed rate loan that waives off the prepayment penalty after a few years.
#4 EMI in Arrears vs. EMI in Advance
EMI in arrears is your regular loan EMI.
Under Loans with EMI in Advance, the first EMI is adjusted with the disbursed amount, effectively reducing the loan amount. Thus, the EMI is also lower compared to EMI in arrears loan product.
The cost of the loan remains the same unless there are fixed charges such as the processing fee. Such fixed charges will increase the cost of ‘EMI in Advance’ more.
No significant difference.
The only thing you need to watch out for — If you focus on just the EMI amount to assess your affordability, the lender/agent can tricky you with a lower EMI (through ‘EMI in Advance’ product) without offering you a lower interest rate.
I discussed this aspect in detail in an earlier post.
#5 Flat Interest Rate vs Reducing Balance Loan
You are unlikely to fall for this in India since I have not seen leading lenders offering such products. Still, a loan is a contract and there is no bar on such products. Thus, it is good to consider this aspect in this post.
Let’s say the banks are offering car loans at 8.5%-10% p.a. You have been hunting for a better rate.
Suddenly, you find a lender offering you the car loan at 7% p.a. Nil processing fee.
The only caveat (and you may not notice): It is a flat rate loan (and not reducing balance loan).
What is the difference? Huge.
Flat rate loan: The calculation works differently. First, you calculate the interest on the total loan amount for the entire tenure.
3-year-loan tenure. 5 lacs loan. 7% p.a.
Interest for 3 years = 5 lacs x 7% p.a. x 3 years = Rs 1.05 lacs
EMI = (Loan Amount + Total interest over the loan tenure) ÷ Loan Tenure in months
= 6.05 lacs ÷ 36 = Rs 16,805
Reducing balance loan: You are charged interest only on the outstanding balance every month.
What was the EMI for the same Rs 5 lacs (reducing balance) loan at 9% p.a. for 3 years?
So, a 7% flat rate loan is more expensive than a 9% reducing balance loan.
For apples-to-apples comparison, a 7% flat rate loan is the same as 12.83% p.a. reducing balance loan.
Beware if the loan interest rate is too attractive.
#6 Loan Insurance Is Not Mandatory
Everybody has targets. Banking staff. Car dealership staff. And even you and me. These targets come in all shapes and sizes. And these targets need not be linked to your primary activity.
So, a banker may be asked to sell insurance policies or mutual funds. Similarly, the staff at auto-dealerships may be asked to cross-sell products.
One such product is loan insurance. In case something happens to you (demise and disability), the insurance company will settle the loan on your behalf.
While this is a good feature, you may already have sufficient life, health, and disability. And may not want such a product shoved down your throat.
You may be told that your loan won’t be sanctioned unless you buy this product. And since you are a captive customer, these products can be quite expensive. We have seen this with Home Loan Protection Plans (HLPPs).
Now, there is no bar on cross-selling. Car dealerships and banks can try to sell whatever they want.
But there is a bar on linking the sanction of loans to purchase of third-party products. Banks/NBFCs can’t do that. Note RBI does not regulate car dealerships.
If you are being pressurized, simply send an email to customer care of the bank and ask if there is such a rule. The banks can’t confirm this over email and will answer in the negative. This problem will auto-resolve.
#7 Higher the CIBIL Score, Lower the Interest Rate
Banks/NBFCs now link the interest rate to your CIBIL score. You can check this on the SBI website too.
I understand you cannot change your CIBIL score overnight but there is an incentive to keep an eye on your CIBIL score and keep it high.
#8 Everything Is Negotiable
The price of a car is negotiable. The freebies are negotiable. Yes, there is give and take but you can negotiate.
Car insurance is negotiable. Well, you must buy car insurance. Just that you don’t have to buy from the dealership. No matter how much your dealer insists, there is no compulsion to buy car insurance (not loan insurance) through the car dealership. You can easily save 20-30% of the insurance cost if you bypass the dealership and buy car insurance directly.
Even if you are taking a loan through a dealership (dealerships have tie-ups with lenders), you can negotiate. The dealerships act as sourcing agents for the lenders and get commission for loans booked. From what I understand, the dealership gets a range of interest rates from the lenders to book loans at. The higher the loan interest rate, the more is their commission. To book the sale, the dealership might offer you a lower interest rate.
You just need to ask and be firm. There is not much to lose. And yes, do not club everything and then haggle. Negotiate for these benefits separately.