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Should you go for floating rate car loan?

Choose your loan type depending on your risk taking capacity and your outlook on interest rate movement for the next few years.

Harsh Roongta

14 Sep 2007

Should you go for floating rate car loan?

ICICI Bank recently announced the introduction of floating rate car loan -- a first among the banks that are very active in car loans. Floating rate option till now was available only for the longer tenure home loans. But is it a viable option for the short tenure -- 3 to 5 years -- car loans?

First, let us look at the interest rate differential available between the floating rate and fixed rate car loan offered by ICICI Bank. The differential is only 50 basis points (100 basis points make 1%). That is, if you can get a fixed rate car loan from ICICI Bank for 14%, then if you are opting for a floating rate, you could get the loan for 13.5%.

Your outgo for the fixed rate loan will remain the same for the entire loan tenure -- whether the interest rate move up to 16% or it moves down to 12%. On the other hand - at least technically in a floating rate option - your outgo will reduce if the interest rate moves down or your outgo increases if the interest rate moves up.

In such a scenario, the straight forward answer is to choose your loan type depending on your risk taking capacity and your outlook on interest rate movement for the next few years.
1. If you do not want to take any risk and wants to freeze your outgo, go for a fixed rate car loan.
2. If you are willing to take risk, but you think interest rate is going to rise, again the best option for you is fixed rate loan. This way you would have locked yourself at a lower interest rate than your anticipated future higher interest rate.
3. If you believe that interest rate will move down in the next few years, the ideal option would be to take a floating rate car loan. This way interest rate on your car loan also will move down, at least theoretically.

These are ideal scenarios, but in real life, things work out a little differently.

Is there a guarantee that banks will reduce interest rate on your floating rate car loan if the general interest rate starts moving down? Sadly, there is no such guarantee. There is no past experience to rely on for car loans. But we have some experience with floating rate home loans.

Since interest rates have been consistently moving upwards for the last 3-4 years, there is no immediate past data for us to check about banks behavior when general interest rate moved down. The most immediate past where interest rate consistently moved down for long duration was during 2001 to 2003 period.

During that period, almost all banks were slower in decreasing interest rate for their existing floating rate loan consumers compared to the briskness with which they have increased interest rates on existing floating rate loans during 2004 to 2007 period.
 
A floating rate loan has three components: (1) Effective rate (the actual interest rate applicable to a loan. Lets assume it is 14%), (2) Benchmark rate (this is only a reference or benchmark rate, which is normally a little lower or higher than the actual rate. Lets assume this is 12%) and (3) mark up or mark down (This is the difference between the benchmark rate and the actual rate. In our instance, it is 14-12=2% or the effective rate is benchmark rate plus the markup of 2%).

Banks change the effective rate by changing the bench mark rate or mark up rate. If the bank drop  benchmark rate by 1%, automatically, your effective interest rate goes down by 1%, i.e 11% (benchmark rate)+2%(markup) =13%. Similarly the bank can also effect a drop in interest rate by changing only the mark up rate to 1% and by keeping the benchmark rate same. In such cases, the effective interest rate becomes 12%+1%=13%. Very often the rate drops are effected through change in the markup rates only while the benchmark rate remains the same.  What this means is that only the new consumers get the benefit of the reduced rates since existing consumers are already locked into their markup rates.

Recently quite a few banks have announced 50 basis point rate reduction in their  home loan rates after a gap of many years. This has been done through reduction in the markup rate by all the banks. Since it is a change on the mark-up it will not have an effect on existing loans. Had the banks made a rate reduction by cutting the benchmark rate, existing borrowers too would have had their interest rate reduced.
 
The other factor is prepayment charge. In the case of home loans this tends to be around 2% of the amount pre-paid. So if the interest rates have dropped a lot and the bank has withheld giving you the benefit by changing only the mark up you can always threaten to shift your home loan and force the bank to pass on the benefit to you as well. In the case of car loans the prepayment charge is as high as 5%. Hence you are more or less locked in to your existing lender.

So before you jump for the floating rate car loan, please pause for a minute. Given the fact that the differential between the fixed rate and floating rate is only 50 basis points and that the prepayment charges are so high and the chances of your benefiting from any general decrease in rates (but you continue to run the risk of paying more if the general interest rates increase) it might make better sense to stick to fixed rate car loan.