The car manufacturers have been badly hit by the lockdown, most reporting zero sales in the month of April. The cashflows of their potential customers are also possibly stretched and uncertain. There have been salary cuts and layoffs. Not good. But there is a positive too. The desire to avoid public transport can increase demand for two-wheelers and cars.
As the economy prepares to open gradually, the car manufacturers would want to cash on this demand by making it easier to purchase cars and two-wheelers. I read quite a few articles about Maruti Suzuki, tying up with HDFC bank and ICICI bank to launch unique car loan schemes. I believe You will hear about many such tie-ups between lenders and manufacturers in the coming months.
These loan schemes can take different names. Since the aim is to reduce the EMI burden on the borrowers initially, here are a few things that lenders (in a tie-up with car manufacturers) can attempt.
- Step-up Loan: A repayment schedule where the monthly payment (or EMI) increases by a certain percentage every year. Let us say the EMI increases by 10% every year. Clearly, you will have to pay a lower amount in the first year.
- Balloon Repayment: You pay a portion of the principal lumpsum at the end of the tenure. Since the EMIs will have to repay lesser principal, the EMI burden will be lower. An extreme case would be a Bullet repayment, where you pay only the interest for the entire duration, and at the end of the loan tenure, you repay the entire principal one-shot
- Teaser Loan: Offer a lower interest rate initially and a higher interest rate later, sort of a teaser loan. For instance, you pay 5% fixed rate for the first year and a floating rate (potentially with a higher than normal spread) for the remaining years. I am not sure if the Reserve Bank will take a kind view of such repayment structures.
We can also have a mix of these schemes. For instance, the lenders structure a schedule that is a mix of step-up loan and balloon repayment. Remember, when you pay less in the beginning, you will have to pay more towards the end. Since interest does not take a holiday, you will end up paying more overall. The cost of the loan remains the same though.
Let us understand the repayment schedules with the help of an example.
For comparison later, a regular car loan of Rs 6 lacs at 10% p.a. for 5 years will have an EMI of Rs. 12, 748.
Step-up Loan: Illustration
Loan Amount: Rs 6 lacs, Interest Rate=10% p.a., Loan Tenure: 5 years
EMI increases by 10% every year.
For this loan, the monthly instalment shall be Rs. 10,640 in the first year, Rs 11,704 in the second year, Rs 12,875 in the third year, Rs 14,162 in the fourth year and Rs 15,178 in the fifth year. So, you pay less than the regular loan EMI (Rs 12,748) initially and more later.
If the EMI were to increase by 15% every year, you will have to pay an even lower amount initially.
Balloon Repayment: Illustration
We continue with the same example.
Loan Amount: Rs 6 lacs, Interest Rate=10% p.a., Loan Tenure: 5 years
EMI remains constant through the tenure.
25% of the principal to be paid at the end of the loan tenure.
The EMI will Rs 10,811. At the end of the loan tenure, you will have to pay an additional Rs 1.5 lacs (25% of 6 lacs).
You pay a total of Rs 10,811 X 60 +Rs 1.5 lacs = Rs 7.98 lacs to close the loan (Rs 7.64 lacs in the regular EMI loan).
Mix of step-up and balloon repayment: Illustration
Now, let’s fire up the creativity engine. Let’s make it so complex so complex that no one can understand.
Loan Amount: Rs 6 lacs, Interest Rate=10% p.a., Loan Tenure: 5 years
EMI increases by 10% every year. (Step-up)
25% of the principal to be paid at the end of the loan tenure. (Balloon)
EMI of Rs 9,024 in the first year. Rs 9,926 in the second year. Rs 10,918 in the third year. Rs 12,010 in the fourth year. Rs 13,211 in the fifth year. Rs 1.5 lacs to be repaid at the end of the tenure (60th month).
Teaser Loan
You pay a low fixed rate in the first few month or the entire year. Then, you move to a higher interest rate. The higher interest rate could be fixed or floating. For a floating loan, the loan can have higher spread compared to a regular floating loan. OR you may just be required to pay the interest in the first year and then principal repayment begins from the second year.
RBI, the banking regulator, does not hold a kind view of teaser loans since such loans can give a false view of the repayment ability to the borrower. The borrower may struggle later to repay the loan.
What should you do?
Not every decision is a financial decision. And the ownership of a car or two-wheeler is no different.
Step-up loan and balloon loan repayment schemes are fine structures. I do not have any problem. Since the loan is short term, the impact on absolute interest outgo is also not high.
Still, there are a few things you must consider before signing up.
- Get an objective sense of your repayment ability. Some people believe that their salaries will go back to their original levels in a few months. That may not happen. Build uncertainty in your plans.
- Do not purchase a more expensive car (than you planned) just because the EMI burden is low. A lower EMI initially can also mean higher eligibility.
- You may get good discounts on car purchases these days. Do not negotiate the car and loan deal together. First, get the best deal on the car and only then disclose your loan requirement.
Do not these are not just the only ways that a loan repayment can be structured. Understand the loan structure properly before signing up.
