Common Misconception: Using Savings or FD to Avoid Loans
Imagine you want to buy a car worth ₹10 lakh. You have ₹10 lakh sitting in a fixed deposit earning 8% annual interest. The natural instinct for many is: “Why take a loan and pay interest when I already have the money? I’ll just break my FD and buy the car outright.” This seems logical on the surface — after all, why pay interest if you can avoid it?
However, this approach overlooks some critical financial principles: the power of compound interest on your FD, the structure of loan repayments, and the impact of inflation on your monthly installments. Let’s break these down.
The Power of Compound Interest on Fixed Deposits
Fixed deposits are one of the safest investment options in India. They offer a fixed interest rate, typically compounded annually or quarterly, which means you earn interest not only on your principal but also on the interest accumulated in previous periods. This compounding effect leads to exponential growth over time.
For example, if you invest ₹10 lakh at 8% annual interest compounded yearly, after 8 years your FD will grow to approximately ₹17.99 lakh. This is calculated using the compound interest formula:
Amount = Principal × (1 + r)^n Where: Principal = ₹10,00,000 r = 8% = 0.08 n = 8 years Amount = 10,00,000 × (1 + 0.08)^8 ≈ ₹17,99,000
That’s an additional ₹7.99 lakh earned purely from interest. If you break your FD today to buy the car, you lose out on this potential growth.
How Car Loans Work: Reducing Balance and EMI Structure
Car loans usually come with fixed interest rates and a fixed tenure. The monthly installment you pay (EMI) consists of two parts: interest on the outstanding loan balance and repayment of the principal. Importantly, the interest is calculated on the reducing balance — meaning as you pay off the principal, the interest component decreases over time.
Let’s consider an 11% annual interest car loan for ₹10 lakh over 8 years. Using the standard EMI formula, your monthly EMI would be approximately ₹14,900.
Over 8 years (96 months), the total amount paid would be:
Total Payment = EMI × Number of Months = ₹14,900 × 96 ≈ ₹14,30,400
This means you pay about ₹4.3 lakh as interest over 8 years. While this seems like a lot, remember that your monthly payments reduce the principal, and the interest portion decreases every month.
Comparing Total Outflows and Inflows: Loan vs FD
Now, let’s compare the two scenarios side by side:
| Scenario | Initial Outflow | Total Outflow Over 8 Years | Value of FD After 8 Years | Net Position |
|---|---|---|---|---|
| Break FD and Buy Car | ₹10,00,000 | ₹10,00,000 (one-time) | ₹0 (FD broken) | Own car, no FD growth |
| Take Loan, Keep FD | ₹0 (initial) | ₹14,30,400 (EMIs) | ₹17,99,000 | Own car + ₹3,68,600 net gain |
At first glance, paying ₹14.3 lakh in EMIs seems more expensive than breaking the FD and paying ₹10 lakh upfront. But remember, your FD continues to grow and compounds to ₹17.99 lakh over 8 years. After subtracting the total EMI paid, you are left with a net gain of approximately ₹3.68 lakh — effectively making the loan plus FD scenario financially beneficial.
Inflation: The Silent Wealth Builder
Inflation erodes the purchasing power of money over time. In India, the average inflation rate has hovered around 5-6% annually over the past decade. What does this mean for your loan EMIs and FD returns?
Your monthly EMI remains fixed in nominal terms, but its real value decreases every year as inflation reduces the burden of your payments. For example, an EMI of ₹15,000 today would feel like paying only about ₹8,400 ten years from now in terms of today’s money (assuming 6% inflation).
Conversely, your FD interest rate is nominal, so the real return after adjusting for inflation is lower. If your FD yields 8% and inflation is 6%, your real return is approximately 2%. This means your FD’s purchasing power grows slowly but steadily.
This inflation effect on EMIs and FD returns tips the scales further in favor of taking a loan and keeping your FD intact.
Visualizing Inflation Impact on EMI and FD Value
Below is a simple graph illustrating how the real value of your EMI reduces over time due to inflation, while your FD balance grows nominally:
Real-Life Scenario: Rajesh’s Car Purchase
Rajesh wanted to buy a new car priced at ₹10 lakh. He had ₹10 lakh in a fixed deposit earning 8% interest. Initially, he thought of breaking the FD to avoid loan interest. But after consulting a financial advisor and using the LoanVsFD calculator, he realized:
- Taking an 11% car loan for 8 years would cost him roughly ₹14.3 lakh in EMIs.
- His FD would grow to nearly ₹18 lakh in the same period.
- Adjusting for inflation, his EMI burden would reduce in real terms each year.
- He would end up owning the car and still have about ₹3.7 lakh more than if he broke his FD.
Rajesh took the loan, kept his FD intact, and used the monthly salary to pay EMIs. Over 8 years, he not only enjoyed his new car but also saw his wealth grow — a classic example of smart financial planning.
When Does Breaking an FD Make Sense?
While the above example shows the benefits of keeping your FD intact, there are situations when breaking an FD might be justified:
- Emergency Needs: Medical emergencies or urgent expenses where loans are not feasible.
- High Loan Interest Rates: If loan interest rates are exorbitantly high (e.g., above 15%), breaking FD might be cheaper.
- Short Tenure Loans: If you can repay the loan quickly, the interest cost might be minimal.
- Penalties on FD: If the FD has a very low interest rate or high premature withdrawal penalties.
However, for typical car loans with reasonable interest rates and tenures, keeping your FD and taking a loan generally works better.
Assets vs. Liabilities: Understanding What You’re Buying
It’s important to differentiate between assets and liabilities. An asset is something that appreciates or generates income over time, like property or stocks. A liability is something that depreciates or incurs ongoing costs, like cars or gadgets.
Cars are generally liabilities — they depreciate in value quickly. So, taking a loan to buy a depreciating asset might seem counterintuitive. But when you consider the opportunity cost of breaking your FD, the loan becomes a tool to preserve and grow your wealth.
This is why many financial advisors suggest avoiding loans for liabilities unless you have a strong cash flow to manage EMIs without stress.
Summary: Key Takeaways
- Fixed deposits grow exponentially through compound interest over time.
- Car loans use reducing balance interest, making interest payments decrease over tenure.
- Inflation reduces the real burden of EMIs year after year.
- Keeping your FD intact while taking a loan can lead to a better net financial position.
- Use financial calculators to analyze your specific case — don’t rely on gut feeling alone.
- Be cautious about loans for depreciating assets and avoid overextending your budget.
Try the LoanVsFD Calculator Yourself
Every financial situation is unique. The LoanVsFD app provides an easy-to-use calculator that lets you input your loan amount, interest rates, FD rates, tenure, and inflation assumptions to see the real numbers behind your decisions.
Download the LoanVsFD app on the Play Store today and make smarter, data-backed financial choices.
Final Thoughts
Breaking your fixed deposit to buy a car might seem like a straightforward way to avoid loan interest. But when you consider the power of compounding, loan amortization, and inflation, taking a car loan while keeping your FD intact often leads to better wealth accumulation and financial health.
Remember, smart financial decisions are not about avoiding loans at all costs but about understanding when and how to use them effectively.