Fixed vs reducing interest rates: Which to opt to fund your car loan?

Purchasing a car is a dream come true for people of all ages, whether they are salaried or self-employed. Most banks today give customers a variety of perks for funding a car loan, such as a paperless process, no documentation, instant loan disbursement, 100% on-road finance, flexible repayment terms ranging from 12 months to 84 months, and so on. But, the most significant factors that borrowers do not query to the bank are hidden charges and whether the interest rate applicable is fixed or reducing. 

Flat interest rates effectively remain higher than reducing interest rates, and the interest rates remain fixed during the loan’s tenure, which is determined based on the principal amount of your car loan. Under the reducing balance rate method, the interest rate is determined solely on the outstanding loan amount on a monthly basis. So when it comes to flat vs reducing interest rates, which option should borrowers go for their car loan, let’s know from experts.

S Ravi, Former Chairman of Bombay Stock Exchange (BSE)

When taking out a car loan, the lender may offer either a fixed or a reduced (also known as a variable) interest rate.

A fixed interest rate remains the same throughout the term of the loan. This means that your monthly payments will remain the same and you’ll know exactly how much you’ll be paying over the life of the loan. Fixed interest rates are often preferred for their stability and predictability, making it easier for borrowers to budget and plan for payments.

A reduced interest rate or diminishing interest rate, on the other hand, can fluctuate over the course of the loan. This means that your monthly payments could go up or down depending on changes in the interest rate. Reduced interest rates are often lower initially, but can increase over time, resulting in higher payments.

Both fixed and reduced interest rates have advantages and disadvantages; the best option will depend on your specific financial situation, preferences and repayment capacity.

Example of Fixed Interest Rate: If you take a 1 lac loan with a flat rate of interest on 10% p.a for, let’s say 5 years, then you would end up paying Rs. 20000 (principal repayment @1 lac/5) + Rs. 10,000 (interest @10%) which equals to Rs. 30,000 p.a or Rs. 2500 per month.

Example of Reducing Interest Rate: if your loan is 1 lac at 10% interest p.a. For 5 years, then your EMI would reduce with every repayment. In the 1st year, you will pay Rs. 10,000 as interest, in 2nd year you will pay Rs. 8000 as interest on a reduced principal of Rs. 80,000 and so on till the last year where you will pay Rs. 2000 as interest. The interest rate us calculated only on the outstanding loan amount on monthly basis in this method.

Nehal Gupta, Director, AMU Leasing

Before taking out a car loan, it’s essential to understand the difference between fixed and reducing interest rates. A fixed interest rate remains constant throughout the loan tenure, while a reducing interest rate decreases with each installment payment. Knowing the distinction can save you money and help you make informed financial decisions.”

For example, let’s say you take out a car loan of 1,00,000 with a fixed interest rate of 5% per year for three years. In this case, you’ll pay the same interest rate of 5% per year on the initial loan amount of 1,00,000 throughout the loan tenure, resulting in a fixed EMI (equated monthly installment) amount.

On the other hand, if you take out a car loan of 1,00,000 with a reducing interest rate of 5% per year for three years, the interest rate will be calculated on the outstanding balance amount each month. Therefore, as you make each installment payment, the outstanding loan amount decreases, and so does the interest charged. This results in a variable EMI amount, which decreases over time as you repay the loan.

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