Here’s why you should choose shorter tenures while applying for a car loan

Ahmedabad-based Manju Parekh, 31, works in the marketing division of a textile exporter company. She purchased her first dream car in October 2018. The on-road price of the car was Rs 12 lakh. She paid Rs 2 lakh as down payment and took a car loan for Rs 10 lakh from a private bank at an interest rate of 10.5 percent, at a monthly-reducing rate. While taking a car loan from the bank, she opted for the tenure of eight years. Parekh says, “At the time of taking the loan, I was keen to pay as less as possible on my car loan’s equated monthly instalment (EMI) per month. I did not bother about how much I was going to pay in interest to the lender over the tenure of the loan.”

Parekh simply focused on her EMI amount and opted for long tenure on her car loan. When she approached her financial adviser later for her financial planning, the adviser explained her that interest outgo on the eight-year car loan would be higher, compared to a car loan with a shorter tenure.

These days, most lenders offer car loans for the maximum tenure of seven to eight years. For instance, private banks like Axis Bank and public sector banks like State Bank of India offer longer tenures of eight years on car loans. Sahil Arora, the head of Payment Products at Paisabazaar.com says, “Borrowers should prefer shorter tenures if they can afford the EMIs. While a shorter tenure leads to higher EMI amount, it also results in lower interest costs. A shorter tenure will allow you to pay off your loan sooner.”

This can be proved with the help of an example, which shows the interest payable of a car loan for the tenure of three, five, seven, and eight years. Let’s take Parekh’s illustration with a loan amount of Rs 10 lakh and an interest rate of 10.5 percent at a monthly-reducing rate.

At present, the EMI for an eight-year car loan is Rs 15,440 for Parekh which is almost half of the EMI of Rs 32,500 on a three year car loan. But, the interest paid on an eight-year car loan (long tenure) comes to Rs 4.8 lakh which is around 2.8 times the interest of Rs. 1.7 lakh paid on a three year car loan (short tenure) as per calculations explained in table below:

Table_car loan

Factors which determine why you shouldn’t apply for a long car-loan tenure

1. Higher interest outgo and added financial burden

As explained in the illustration above, the longer your car-loan tenure, the higher the interest outgo will be. This is the primary reason for a borrower to avoid opting for a long loan tenure.

Gaurav Gupta, the co-founder and CEO of the online aggregator of financial products and services MyLoanCare.in, says, “Given that the average usage period of a car is not more than five years before the first time buyer sells is to a second-hand user, the long-term loan tenure will be a hassle since the buyer will continue to repay the outstanding loan on the car even after completing five years. Even a car manufacturer does not give an eight-year warranty, which means there will be heavy maintenance expenditure after the initial three to five years of purchase.” So, the higher maintenance expenditure coupled with the EMI can result in a heavy financial burden for you.

2. Higher interest rates on longer loan tenure

The second factor that works against a long-tenure car loans is that lenders typically have a higher interest rate on long-tenure loans to compensate for the additional credit risk banks are taking on the borrower. You will end up paying 50 basis-points higher interest on the car loan for a longer tenure, compared to a three-year car loan.

3. Avoid buying a car which you cannot afford

There is high likelihood that you are choosing a longer tenure of car loan to get a lower EMI amount. This might indicate that you are trying to buy a car which you cannot afford in the first place at your current income and repayment capacity. Gupta cautions, “The plan to have longer car loan tenures can backfire in the long run, especially as you end up paying way more than the actual cost of the car.” Arora adds, “Moreover, a car is a depreciating asset. So, in the long run, you won’t get any returns while selling off.”

Avoid taking flat rate on car loan

Flat-rate schemes on car loans are misleading for the borrowers as the effective interest rate comes to be significantly higher than the quoted interest rate. In the case of a flat rate method, the interest amount is paid on the original principal loan amount throughout the loan tenure.

Gupta says, “Opt for the reducing balance method while applying for a car loan since every EMI consists of a component of principal and interest paid, and the interest is calculated on the remaining principal amount at the end of each month.”

Let’s consider an illustration, where the car loan amount is Rs 10 lakh, the rate of interest is 10 percent, and the tenure is five years for flat rate. In the flat-rate method, you will pay an EMI of Rs 25,000, and the total interest outgo will be Rs 5 lakh. But, in the reducing-balance method, you will pay an EMI of Rs 21,247, and the total interest outgo will be Rs 2.74 lakh. This comparative illustration clarifies that you will end up paying a much higher interest in the flat-rate method compared to the reducing-balance method.

Car loans are used to buy a depreciating asset, and one should be careful while opting for a car loan. In addition to the rate of interest, you should also check the processing fee, pre-payment charges and other charges associated with a car loan. If you have a good credit score, you can negotiate for better rates and a waiver of charges. This will reduce the effective cost of owning a car.