A friend had to buy a car.
For the funding, he was considering 3 options.
- Break bank FDs and pay for the car
- Take a car loan
- Take loan against the FD
He was not too keen on breaking the fixed deposit. Two reasons. Firstly, he didn’t want to break the FDs. Accumulating a corpus takes time. Taking money out does not. He didn’t want to compromise on discipline. Loan EMIs would get absorbed in their regular cashflows and their expenses would adjust accordingly. Fair thought. Secondly, he would have incurred a penalty in breaking the FD.
Hence, he was down to 2 options. A car loan or a loan against bank FDs. Which is the better choice?
What Were the Family’s Expectations from Their Loan Product?
- Low cost (low interest rate, processing fee and other ancillary charges)
- Flexibility in repayment. He didn’t want to keep the loan for full tenure. Wanted to pay the loan off in the next 2-3 years. Hence, there shouldn’t be any prepayment penalty.
- Hassle-free loan disbursal (do not want much back and forth)
#1 Low Cost
For the bank under consideration, the car loan interest rate was the lowest at 9.20% p.a. for applicants with CIBIL score of more than 720. The rate went up as the CIBIL score went down. For applicants with CIBIL score of 700 or less, the rate was 75 bps higher.
I think this is a good enough incentive for maintaining a good credit score. 75 bps is a huge difference. In this specific case, the credit score was good enough for the best interest rate, i.e. 9.2% floating.
In case of FD backed loan, the loan was offered as an overdraft facility (and not as term loan). Again, this is specific to the bank where he had bank fixed deposits. The loan interest rate was 2% above the bank FD rate. He had bank fixed deposits at ~7.25%. Add 2% to this and the cost becomes 9.25%. Not much difference compared to the car loan. This is a bit disappointing because there is no more convenient security/collateral than a bank FD.
An overdraft facility has a few benefits compared to a term loan where you can make multiple withdrawals as long as the loan outstanding stays within the OD limits. You can also park excess funds in the OD account to save on the interest cost. The only problem is that the overdraft facility will be for a specific period. Say 12 or 18 months. For it to behave like a term loan, it must be regularly renewed. In certain corner cases (even though I have not come across any instance for an FD backed facility), the bank may decline to renew the OD facility. A term loan does not have such renewal concerns.
Processing fee: Loan against FD (overdraft facility) had no processing fee. The car loan had a small processing fee. Less than Rs 1,000. No material difference.
Note: While there may not be any significant difference in interest rates, a car loan is a floating rate loan, and the rate of interest would go down/up if the RBI were to cut/raise repo rate in the future. The FD loan (OD facility) is linked to the FD interest rate and not sensitive to repo rate. Hence, if you expect the interest rates to move down in the future, a car loan becomes a better option at least so far as the loan interest rate is concerned.
#2 Prepayment Costs
Given how an OD facility works, there is no concept of prepayment charges. You can just add to the OD account and reduce your interest outgo for the coming month. When you want to close, you can simply ask the bank to close the OD account. You just have to ensure that there is no net withdrawal from the OD account.
Even for a car loan, since this is a floating rate loan, there were no prepayment or foreclosure charges. Note the bank was also offering a fixed rate loan at a slightly lower rate (about 8.80%) but it had prepayment penalty for up to 1 year. My friend expected the RBI repo rates to go down from here. If that were to happen, the gap between the fixed interest rate and the floating rate will shrink.
#3 Hassle-Free Loan Disbursal
It is difficult to beat an FD backed loan on this front. The loan application and disbursal could be as simple as a few clicks on the bank website or mobile app. Car loan application will clearly take more time.
Which Option to Choose?
Firstly, what I have noted down are the just loan options available to my friend. Your loan options may be different. Your CIBIL score may be different. And that can change everything.
Even in the scenario discussed earlier, the car loan appears to be more favourable in terms of interest rates, especially given the current situation where the likelihood of rates increasing in the near future seems low. However, an FD backed loan offers greater flexibility and a smoother approval process.
Hence, your decision will depend on your preference.
If I were in a similar situation, I would most likely go for the loan against FD (overdraft facility). It gives me a lot of flexibility and ranks high on my priority list. I don’t want to keep furnishing documents to the bank for first getting a car loan and then chase them to remove the charge on the car (hypothecation) once the loan is repaid. However, that’s just me. Your preferences may be quite different.
What will you do?