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Home > Business > Special

Auto loans: Are floating rates good?

Dhvani Desai, Outlook Money | October 26, 2007

The government's liquidity tightening measures this year have pushed up interest rates and slowed down offtake of auto loans. While interest rates have not fallen significantly yet, most experts say they will in future. Typically, the price of an auto loan is set for the entire loan tenure. But now some banks, such as State Bank of India [Get Quote] and ICICI Bank [Get Quote], have started offering floating rate loans too. When interest rates are going down, floaters allow you to reduce your liability. Should you then 
go for them?

The floater rationale
ICICI Bank's auto loans head, N.R. Narayanan, says: "Many customers told us that they were not going in for car loans now since they were expecting the interest rates to get better (fall). We thought we should offer them the floating rate scheme so that they also get the benefit if at all the rates fall." He says ICICI Bank's rates are linked to floating reference rate (FRR), the benchmark used for its home loan floating rates. For other lenders, too, the rationale for launching floating rate auto loans was to keep up the pace of lending.

Reality check
Rate. Broadly, floating rates, say lenders, are 50 basis points (bips) less than fixed rates. However, it pays to shop around as the fixed rates of some lenders are still lower than the floating rates of others (see Floating Rates vs Fixed Rates). In a situation like this, floating rates make no sense unless you are expecting them to fall by more than 200 bips in a hurry.

What does it mean even if the floating rate is, say, 50 bips less than the fixed rate? "It amounts to a saving of Rs 24 per month per Rs 1 lakh of loan for three years," says Sumit Bali, CEO, Kotak Mahindra Prime, which will launch floating rate auto loans soon. For a Rs 5-lakh loan for three years, that means a saving of Rs 120 a month. The flip side is that if the rates rise, you could end up paying more than what you would have paid for a fixed rate loan. In the home loan scenario, floating rates can be as much as 250 bips less than fixed rates. A difference of this much would make floating rates attractive as the EMI would be Rs 600 lower than the fixed rate loan EMI in the example above. 

Tenure. There is no difference between the tenures for the two kinds of loan. Tenures can change in the case of home loans. In auto loans, however, only the EMI changes. Besides, most banks discourage prepayment of the loan�the penalty for that is as high as 5 per cent of the outstanding principal. Unlike home loans, you can't switch between fixed and floating rates in auto loans.

Switching lenders. The high prepayment penalty of auto loans makes it costly to switch to a lower cost lender. Besides, CEO Harsh Roongta says that banks' record for home loans puts a question mark over the amount of benefit borrowers will get. Typically, lenders are prompt in increasing the rates, but not in reducing them. Also, adds Roongta, "banks offer deductions or discounted rates only to new customers."

Depreciation. A car, unlike a house, is a depreciating asset. So, if you take a high proportion of the cost of the car as a loan and the rate keeps rising, you are likely to encounter a situation when the residual value of the car will be less than the outstanding loan amount. So, if you want to discontinue paying EMIs, you will not be able to pay off your debt by selling the car.

What to do 

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