Should I take out an installment loan?

The world of finance is largely built on installment loans. Chances are you have or have an installment loan in your life. In most cases, installment financing will be a good thing. This is how you will pay for your house, your car and your education. In some cases, you may want a personal loan. Yes, it is also an installment loan.

What is an installment loan?

An installment loan usually has several important features.

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When do you receive the money?

With an installment loan, you usually get your money up front. If you borrow $10,000, you receive a check at closing. There are exceptions. For example, with FHA 203k mortgage financing, you get cash at closing to purchase a property and then additional cash to repair the property. Repair money is paid out in “draws” as improvements are completed.

What is the duration of an installment loan?

An installment loan has a fixed term. The term of the loan is usually determined by the purpose.

  • Auto Loans – Approximately 69 months for a new car, 65 months for a used vehicle according to Experian.
  • Mortgages – Usually 30 years, but can be shorter, say 15 or 20 years.
  • Personal loans – Usually one to five years, but can be longer.
  • Student loans – Usually 10 to 25 years, but can last 30 years in some cases.

What type of interest do you pay?

An installment loan can have a fixed or adjustable interest rate. With a fixed rate, there is one rate for the entire term of the loan. This also means that the monthly cost of principal and interest is the same every month. If you borrow $7,500 over three years at 10% interest, the monthly payment is $242.00 for principal and interest. If you borrow $7,500 at 10% interest over five years, the monthly payment is $159.35.

With the longer loan, the monthly payments are lower because there is more time to pay off the debt. However, at the same interest rate, longer loans have higher interest charges than shorter loans. With our loan of $7,500 at 10%, the total interest cost will be $1,212 over three years. Interest charges will be $2,061 over five years.

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Adjustable rate installment loans

With adjustable rate mortgages (ARMs), interest charges can vary depending on whether the rate goes up or down. The rate is usually calculated based on two factors.

First, there is an index not controlled by the lender. Many mortgages, for example, have adjustable interest rates based on the price of 10-year Treasury securities or the federal funds rate. The index can go up or down during the term of the loan.

Second, there is a margin. The “margin” is a fixed number that does not vary over the life of the loan.

Third, combine the index rate and the margin and you get the interest rate.

With ARMs, there is usually a low-cost “start-up” rate to attract borrowers. There are also rate minimums, maximums, and caps that limit interest rate and monthly payment changes.

For an in-depth discussion of ARMs and how they work, it may be beneficial to consult the government’s 42-page guide, The Adjustable Rate Mortgage Consumer Handbook, also known as the CHARM book.

How is the interest on installment loans calculated?

Most installment loan costs are calculated on the basis of simple interest. You take the outstanding loan amount, multiply by the interest rate, and you get the interest cost. When mortgages have fixed rates, you can use an “amortization” statement to see how much of the payment goes to interest and how much goes to principal each month.

Automatic installment loans

Car financing can be completely different. Vehicle financing in many — but not all — states is calculated using the rule of 78. The effect of this rule is to push up interest charges to discourage early loan repayments. The state of Mississippi explains the rule this way:

The rule of 78 is also known as the sum of digits. In fact, the 78 is the sum of the digits of the months of a year: 1 plus 2 plus 3 plus 4, etc., up to 12, equal to 78. According to the rule, each month of the contract is assigned a value which is the exact opposite of its occurrence in the contract. So the 1st month of a 12 month contract gets the value of 12, the second month 11, etc., until the 12th month gets a value of 1. As the months go by, the interest is earned by the lender equal to the total value of the past months.

For example, a prepayment after 2 months of a 12 month contract would allow the lender to keep 29.49% of the finance charges (1st month 12 plus 2nd month 11 = 23/78 or 29.49%). In another example, if the borrower prepays after 6 months, the lender would have earned 57/78s or 73.08% of the finance charge.

As an alternative to the rule of 78, consider financing from a dealership that uses simple interest only or from a bank or credit union.

Are there any charges other than interest for installment loans?

There may be origination fees, prepayment fees if the loan is paid off early, late fees for late or missed payments, transfer fees and other charges.

Instead of just looking at “interest rate”, buy installment loans based on their “annual percentage rate” or APR. The APR attempts to show the interest rate and loan costs together. If two installment loans have the same interest rate but one has a higher APR, financing with the higher APR will include more loan costs and fees.

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