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Make sense of car loans with step-up and balloon payments before borrowing

Fear can be a great motivator. In the time of the Covid-19 crisis, many want to avoid public transport and shared vehicles in order to avoid infection. In such a situation, many who are holding on to their money, are going for pre-owned vehicles instead of new ones, just to avoid a higher EMI. But did you know that banks allow you to customise your EMIs? Sahil Arora, Director, Paisabazaar says, "Many lenders have started offering step-up and balloon repayment options to car loan borrowers." Many auto companies have also tied up with lenders to offer different versions of these repayment options, with some even offering a combination of the two. Banks themselves offer car loan EMI repayment options that are custom fit minus the tie-up. While all the offerings vary slightly, the basic principles behind the payment remain the same. It makes EMI and loans affordable, so understanding the basics is the first step.

Step-up: This option on your car loan allows you to pay less at the outset. Pranjal Kamra, CEO, Finology says, "Under the step-up loan option, the EMI is lower in the initial tenure of the loan, and increases later. The unique feature of the scheme is that it increases the eligible loan amount for a borrower with lower income currently. You don't need to compromise on the car you want just because of lack of finance." This means even if you have suffered a salary cut right now, as time passes and things improve, your salary will also increase, as willl your capacity to repay. Kamra says, "This option is suitable for individuals in the early stage of their career and cannot afford higher EMIs but are expecting salary growth in the coming years. As time goes by, with the increase in the borrower's salary, the loan EMI will also increase." Remember, if you are in a sector that is likely to recover faster, it will be a lot easier to get this repayment option. Do note that the assumption is that your income will rise in the coming years, but if this does not happen, you may land into a debt trap. Kamra says, "Additionally, the overall repayment cost also rises if there is a floating rate and the interest rate goes up." This pretty much could be the case later. If you are certain that your income will be restored in some months, such loans may work for you.  

Balloon payment: This option allows the borrower to pay a lower amount as EMI during most of his loan tenure. The borrower is required to make a large payment at the end of the loan tenure to repay the outstanding loan amount. M Barve of MB Wealth Financial Solutions says "The borrower needs to pay a very low amount in terms of regular installments. Thus the option enables him to access affordable short-term credit. Individuals who have fluctuating monthly income can opt for this kind of repayment." It works if you have a cash crunch right now, but are expecting some lump sum in the coming years, or are disciplined enough to save over the years and make a lump sum payment at the end of the loan. It's like a delayed down-payment--instead of the beginning, you pay it at the end. Arora says, "Some lenders, especially the captive car finance companies, also allow the balloon loan borrowers to get their car valued at the end of the loan tenure and upgrade to a new car." Remember, in case you are unable to pay the lump sum amount; you have to go for refinancing, which leads to a higher interest burden.

The low-EMI months in a step-up or a balloon option vary from bank to bank, and from one auto finance company to another. Arora says, "The biggest drawback of step-up and balloon car loans is their interest costs, when compared to traditional car loan EMIs." Another disadvantage is the assumption of higher repayment capacity in future, based on which car loan borrowers avail these options. Arora adds," If the annual incomes do not increase as per expectations, the borrowers might end up in default on repayment. This might, in turn, have severe consequences on their future loan eligibility."

Some decisions are not about the numbers alone. If you think that extra interest is not as important as your safety, there's no harm in going for the options. But don't go overboard, and avoid getting in a huge debt trap in case you face more challenging times financially in the future. If you go for a balloon, set aside a little amount regularly towards your final payments over time. If the fear of Coronavirus and death can motivate you to buy a car, then the fear of debt and default should motivate to take the right decision. 

TABLE: Total payout on 5-yr loan of Rs 6 lakh @10% under various options
Loan type Total Payment (Rs lakh)
Regular EMI  7.64
Step-up option  7.79
Balloon Option  7.98
Assumptions: In step-up, EMI increases by 10% every year. In  balloon, EMI remains same, 25% principle at end of tenure; Source: Websites

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