Did you know that car sales in India have gone up considerably in the past few months? What’s more is that consulting firm, RedSeer, recently reported that a whopping 75% of new-car purchasers in India buy the car on a loan. Is this a wise decision?
Today we’ll deep-dive into the mechanics of a car loan and explore whether it makes more sense to buy a car on a loan or pay for it upfront, and why.
Buying a Car on a Loan – The Real Costs
All major banks offer car loans. Generally, 80-90% of the on-road price of the car is given as a loan. The balance is paid by the borrower as down payment. The car serves as the collateral for the loan, making this a secured loan. Simply put, this means that if the borrower is unable to repay the loan, the bank has the right to seize the car.
Interest rates on car loans are lower than that on personal loans. However, it is still quite steep. And other charges like loan processing fees, documentation charges, credit rating report charges and GST, though minor, add to the cost of a car loan.
Currently, the range of interest rates across banks in India lies between 7-9% for new cars, and between 14-18% for pre-owned cars. The usual tenure of car loans is 5 years, with some people preferring longer durations of up to 8 years. You only truly own the car once the entire loan has been repaid.
Let’s take an example of what the real cost of a car loan is.
At the end of five years, we have paid a total of ₹9,62,489 for the car, compared to the on-road price of ₹8,00,000. That’s 20% more than the original cost!
Saving Up to Buy a Car – The Real Outflow
Now, what if we didn’t take a loan to buy that car. Say we planned for it, and invested our savings towards it for the next few years.
I would choose a hybrid mutual fund for this purpose. It’s the type of fund that combines the high returns of equity and the stability of fixed income instruments. And it is ideal for a medium-term goal horizon of 3-5 years.
This option involves waiting to buy something that you aspire to own. But it is one of those many instances where delayed gratification trumps instant gratification. Taking a car loan meant we paid ₹9.62 lakhs for an ₹8 lakh car. Whereas saving up for it meant we were able to afford a ₹9.80 lakhs car by investing just ₹7.80 lakhs! You could possibly get a higher-end model, or an electric car perhaps! Not only do you have more to spend on the car, but you are also able to fully own the car in a shorter timeframe of 4 years. All this without the burden of debt.
Wealth is What You Don’t See
Author and behavioural finance expert, Morgan Housel, in his book, The Psychology of Money, dedicated a chapter to this ironical fact about money. Wealth is what you don’t see.
Housel narrates the story of a man named Roger, who used to drive around a Porsche. Roger later switched to an old Honda. When asked about the switch, Roger simply stated that the bank had repossessed the car after he’d defaulted on the loan. All the assumptions that Housel, and many others like you and me, had made about this man were wrong. The Porsche was only perceived wealth.
“Someone driving a $100,000 car might be wealthy. But the only data point you have about their wealth is that they have $100,000 less than they did before they bought the car (or $100,000 more in debt). That’s all you know about them.”
The Wise Choice
A car is a depreciating asset. The value of a new car drops around 15-20% after the first year of ownership. Subsequently, it depreciates by 10% every year. On top of that, as soon as you buy the car, you start incurring expenses on running and maintenance. Why add an interest component to all this?
Avoiding loans as far as possible is an excellent practice to follow. There are only two situations that warrant borrowing money – a medical emergency for which you do not have sufficient funds and taking a home loan to buy a house for your own residence.
Further, there’s a useful rule of thumb that helps you know when you are financially ready to buy a car. It is when your annual earnings are at least 2-3 times the value of the car.
With a plethora of commuting options at our disposal, owning a car is hardly ever going to be an urgent requirement. So it’s best to “reverse EMI” your car purchase. Save up for it by taking the SIP route instead of going down the loan-EMI route.
Wealth is hidden. It’s income not spent. Wealth is an option not yet taken to buy something later. Its value lies in offering you options, flexibility, and growth to one day purchase more stuff than you could right now.
Morgan Housel, The Psychology of Money
Postpone buying that. Steer clear of car loans. And if you are someone who has been in the habit of investing a portion of your salary every month, regardless of financial goals, you might even be able to afford a car sooner rather than later.
