The customer today faces a daunting task of selecting from among the plethora of features and combinations that are being offered by the financing institutions on every kind of loan. Competition among the financiers has led to the development of many innovative loan products which have their own pros and cons. In order to see through the smoke screen of marketing and evaluate the features of any scheme one will have to undertake a little bit research and compare the products in order to avail the best deal on a car loan for himself. The basic types of car loans available currently in the market are the fixed rate and floating rate interest car loans. Both the variants have their own strengths because of which they enjoy popularity amongst customers.
Essential Differences
Simply put a floating rate loan is that whose interest is calculated as per the prevailing Floating Reference rate (FRR), which is the benchmark rate used by all banks to price their floating rate loans. This rate may vary periodically. The fixed rate loan on the other hand remains at a fixed value throughout the tenure of the loan irrespective of the fluctuations in the benchmark rate.
Any floating rate loan essentially has 3 components:
- The Effective rate (the actual interest rate applicable to a loan. Lets assume it is 14 per cent),
- The Benchmark rate (this is only a reference or benchmark rate, which is normally a little lower or higher than the actual rate. Lets assume this is 12 per cent) and
- The Mark up or mark down (This is the difference between the benchmark rate and the actual rate. In our instance, it is 14-12=2 per cent or the effective rate is benchmark rate plus the mark up of 2 per cent).
Typically the banks change the effective rate by changing the bench mark rate or mark up rate. When the bank drops the benchmark rate by 1%, then the effective interest rate reduces by 1%, which is 11 (benchmark rate) +2 %(mark up) =13%. Likewise the bank can also effect a drop in interest rate by changing only the mark up rate to % and by keeping the benchmark rate same. Now the effective interest rate becomes 12 % +1 %=13%. Normally the rate drops are done through changes in the markup rates only when the benchmark rate remains the same. This implies that only the while the new customer will benefit from the reduced rates the existing ones will stay locked up in higher marked up rates.
Considerations while Opting for Type of Loan
While opting for the type of loan one has to consider a few points:
- Those who do not have appetite for risk and wish maintain a steady repayment must freeze their loan with fixed rate type.
- For those who are willing to take the risk the prediction of the trend of interest rates in the future years is the basis of consideration. If there is likelihood of an upward trend in the interest rates then it is preferable to stay locked in a fixed rate loan. If trends indicate a downward movement in interest rates then opting for a floating type may be beneficial in the long run.