Used-car loan traps: How to reduce borrowing risks, keep EMIs manageable

Compare rates, choose a short tenure, make a larger down payment, and keep EMI within manageable limits

Used-car financing has recorded rapid growth, with a five-year compound annual growth rate (CAGR) of 26.2 per cent, and the borrower base expanding 2.4 times between June 2021 and June 2026, according to credit bureau CRIF High Mark. Buyers must factor in higher borrowing costs, conservative loan-to-value (LTV) ratios, shorter tenures and the risk of owing more than a depreciating car is worth before going for a used-car loan.

 

Understand the differences

 

A used car is a depreciated asset. “Used-car loans generally carry higher interest rates because the vehicle has already depreciated,” says Adhil Shetty, chief executive officer (CEO), BankBazaar. Lenders also tend to offer more conservative LTV ratios and shorter tenures for them because the vehicle has a shorter remaining life and a less predictable resale value.

 

What determines the rate?

 

The lender evaluates both the borrower and the vehicle before it sets the interest rate. A borrower’s credit history, income stability, repayment record and employment profile influence the rate. A strong borrower profile can help secure a lower rate, while a lower credit score, irregular income or high existing debt can increase it.

 

The lender also considers the car’s age, make, model, condition and resale value. “A popular model with strong resale value and deep secondary-market demand presents a different risk from a vehicle that may be harder to sell,” says Shivanshu Makkar, chief financial officer (CFO) for India, Cars24. 

 

Older vehicles may attract higher rates or stricter terms because their value and remaining useful life are lower. “Lower uncertainty about either the customer or the car is likely to result in better financing terms,” says Makkar.

 

Vehicle valuation and LTV

 

The seller’s asking price and the lender’s valuation may differ. “Lenders typically finance a percentage of the vehicle’s assessed value rather than automatically financing the seller’s asking price,” says Makkar. 

 

Shetty adds that some lenders finance up to around 90 per cent of a used car’s current value, compared with the higher financing available for new cars. 

 

“If the assessed value is lower than the seller’s asking price, the customer may have to make a larger down payment,” says Makkar.

 

Impact of vehicle’s age

 

The vehicle’s age helps the lender estimate its remaining useful life and resale value, and can affect both eligibility and tenure. “Lenders generally become more conservative about the financed amount and offered tenure as a vehicle gets older,” says Makkar. 

 

Some lenders set a limit on the maximum vehicle age by the end of the loan. “Some use a combined age-and-tenure limit of around eight to 10 years,” says Shetty.

 

Limit tenure 

 

Base the tenure on repayment capacity, the car’s age and its likely future value. Do not stretch the loan only to make the equated monthly instalment (EMI) appear affordable. “Borrowers should choose the shortest tenure whose EMI they can service comfortably rather than the longest tenure that makes the EMI appear small,” says Akash Bararia, head of consumer finance, HDB Financial Services.

 

A longer tenure increases the total interest cost. It can also create a mismatch between the outstanding loan and the car’s resale value. “The borrower should ideally not owe more than the car is worth at any point during the tenure,” says Bararia. The loan should also not outlive the vehicle’s working life.

 

Strike a reasonable balance between tenure and EMI. “A tenure of 36 to 48 months can balance monthly cash flow and keep the loan within the vehicle’s remaining lifespan,” says Abhishek Kumar, Securities and Exchange Board of India (Sebi)-registered investment adviser and founder, SahajMoney.com. A borrower who selects a longer tenure should consider prepayment or refinancing as their income grows.

 

Down payment and debt limits 

 

The right down payment depends on the borrower’s financial position, cash flow, repayment capacity and existing obligations. “A larger down payment is advisable when the borrower has surplus funds and the resulting EMI falls comfortably within the affordable range,” says Amit Kakkar, CEO, Spinny Capital. A larger down payment reduces the total interest cost. It makes particular sense for a used car as their value depreciates faster. 

 

“A down payment of 20–30 per cent is advisable,” says Kumar. A higher upfront contribution also reduces the risk that the outstanding loan will exceed the car’s value.

 

At the same time, do not completely exhaust savings to maximise the down payment. “Borrowers should retain a cushion for emergencies when deciding the EMI,” says Kakkar. 

 

Bararia adds that they should budget for insurance, fuel and servicing in addition to the EMI.

 

Kumar suggests that total vehicle-related expenses, including the EMI, insurance and routine maintenance, should not exceed 15–20 per cent of net monthly income. 

 

A person’s total debt burden should remain serviceable. “A useful rule of thumb is to keep all EMIs together within 40–50 per cent of take-home pay,” says Bararia. Borrowers should decide the EMI they can afford first, then choose the loan amount and tenure. 

 

Compare lenders

 

Look beyond the headline interest rate when comparing lenders. “Borrowers should compare the total loan cost, including interest, processing and documentation charges, foreclosure or prepayment charges and other applicable costs,” says Kakkar. 

 

Kumar suggests checking vehicle valuation costs and mandatory insurance bundling that may increase the total cost of ownership. 

 

Review EMI bounce charges and penal interest, along with foreclosure and part-payment provisions. “Foreclosure and part-payment terms require particular attention when the borrower is likely to prepay or close the loan early,” says Kakkar. 

 

Compare the LTV ratio and the turnaround time for issuing the loan. “Borrowers should obtain written confirmation for every charge and the basis of the interest rate before signing,” says Bararia.

 

Read loan documents

 

Read the sanction letter and loan agreement for hidden charges, restrictions and unclear terms before signing the loan agreement. Ask the lender to clarify every doubt and review the Key Fact Statement (KFS). “Borrowers should review the annualised percentage rate in the KFS to understand the effective borrowing cost,” says Kakkar.

 

Pay every EMI on time because a delay can hurt the credit record. Check the process for removing the lender’s hypothecation from the registration certificate and obtain a no-objection certificate after closing the loan. “Borrowers should never pay cash to an agent for loan processing because a transparent lender will not seek a cash payment,” says Bararia. 

 

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The writer is a Mumbai-based independent journalist