Buying a new car? Don't opt for a floating rate loan

Vaibhav Aggarwal explains how borrowers lose when they go for floating loans.

ICICI Bank recently introduced a floating rate car loan. With this ICICI has become the first among the private banks and non-banking finance companies (NBFCs) to offer this to retail loan customers. Until now, the floating rate option was only available for long-term housing loans.

The bank has linked the floating rate to floating reference rate (FRR), the benchmark rate used by bank to price its floating rate loans to retail customers.

However, the question arises: Is a short tenure (3 to 5 years) floating rate car loan a feasible option?

Consider the differential between the two rates

Let us consider ICICI's floating rate car loan offer. Currently the floating rate available to customers is 50 basis points (half a percentage point) lower than its equivalent fixed rate product.

That means that if you can get a fixed rate car loan at 13 percent, you can avail floating rate car loan at 12.5 per cent.

If you opt for fixed rate car loan, the interest that you pay would be same for the entire tenure of the loan whether the interest rate increases to 15 per cent or drops down to 11 per cent.

On the other hand, if you go for a floating rate car loan, your outgo will reduce if the interest rates go down and it will increase if the interest rate increases.

In such a situation, you should choose the type of car loan depending upon your position on future interest rate movement.

That is, if you expect the interest rate to rise, you should go for a fixed rate car loan.

If you think that the interest rates would go down in future, opt for a floating rate car loan.

In case you do not want to make any conjectures and take any risks, go for the fixed rate car loan.

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Do you actually benefit from floating rate loans if interest rates decline?

Banks do not guarantee reductions in floating rates if interest rates decline. There is no record to rely on for car loans but things can be inferred from borrowers' experience with floating rate home loans.

As there has been a consistent increase in interest rates for the last 3, 4 years, there is no past data for us to check about banks actions when the general interest rates declined.

The most recent duration for which interest rates were on a downward slope was 2001-2003. During this time, banks were slower in reducing the rates as compared to the speed with which they increased floating home loan rates during the 2004-2007 period.

A floating home loan rate consists of:

1. Effective rate: This is the actual rate of interest applicable to a particular loan.

2. Benchmark rate: This is a reference rate. It is usually a little higher or lower than the actual rate.

3. Mark up/mark down rate: It is the difference between the benchmark and the actual rate.

Suppose the effective rate is 15 per cent and the benchmark rate is 13 per cent, then the mark up rate is 15 minus 13, 2 per cent.

In other words the effective rate is the sum of benchmark rate (13 per cent) and mark-up rate (2 per cent).

Banks alter the effective/ actual rate by altering the benchmark or the mark up rate.

For instance, if a bank reduces its benchmark rate by 1 per cent, the effective rate automatically decreases by 1 per cent. (12 per cent + 2 per cent = 14 per cent).

Similarly, a bank can also reduce the effective rate by reducing the mark up rate by 1 per cent and keeping the benchmark rate unaltered.

In such a scenario, the effective rate sums up to 14 per cent (13 per cent + 1 per cent). Often banks reduce rates by changing the mark up rates, keeping the benchmark rates same.

This implies that the benefit of revised rates is only passed on to the new customers since existing customers are already locked into their mark up rates.

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The other factor is the prepayment charge.

Prepayment charges applicable to home loans are around 2 per cent of the amount prepaid.

Therefore, if there is a huge decline in the interest rates and banks have only altered the mark up rates they have not provided you the benefit of this decrease.

In case of car loans, the prepayment charges are around 5 per cent.

Therefore, before deciding to opt for a floating rate car loan, consider the differential between the fixed rate and the floating rate, and the prepayment charges.

If the differential between the rates is low and the prepayment charges high, going for a fixed interest car loan is a wiser decision.