Do I have to get an installment loan?

The world of finance is built largely on the installment loan. The chances are huge that you have or will have an installment loan in your lifetime. 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 characteristics.

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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 get a check on closing. There are exceptions. For example, with FHA 203k mortgage financing, you get money on closing to buy a property and then extra money to fix the property. Repair money is paid out in “raffles” as the upgrades are completed.

What is the term of an installment loan?

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

  • Auto loans – About 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 kind of interest are you paying?

An installment loan can have a fixed or adjustable interest rate. With a fixed rate, there is a rate for the entire term of the loan. It 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 loan terms. With our $ 7,500 loan at 10%, the total interest cost will be $ 1,212 over three years. The cost of interest will be $ 2,061 over five years.

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Adjustable rate installment loans

With variable rate mortgages – ARMs – interest charges can vary depending on whether the rate goes up or down. The rate is generally calculated on the basis of two factors.

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

Second, there is a margin. The “margin” is a fixed number that does not change 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 “seed” rate to attract borrowers. There are also minimum, maximum, and cap rates that limit changes in interest rate and monthly payment.

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

How is interest on installment loans calculated?

Most installment loan fees are calculated on the basis of simple interest. You take the outstanding loan amount, multiply it 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 is going to interest and how much is going to principal each month.

Installment auto loans

Auto financing can be completely different. Vehicle financing in many states – but not all – is calculated under the Rule of 78s. This rule has the effect of advancing interest charges to discourage loan prepayments. The state of Mississippi explains the rule this way:

The rule of 78 is also known as the sum of the digits. In fact, the 78 is a sum of the digits of the months in a year: 1 plus 2 plus 3 plus 4, etc., to 12, equals 78. As a rule, each month in the contract is assigned a value that is exactly the reverse of its occurrence in the contract. Therefore, the 1st month of a 12 month contract gets the value of 12, the second month 11, etc., until the 12th month has a value of 1. Over the months, interest is charged by the lender equal to the total value of the expired months.

For example, a prepayment after 2 months of a 12 month contract would allow the lender to keep 29.49% of 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% finance charges.

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

Are there any charges other than interest for installment loans?

There may be a set-up charge, prepayment charge if the loan is prepaid, late charge for late or missing payments, transfer fees, and other charges.

Instead of looking at just the “interest rate”, buy installment loans based on their “annual percentage rate” or APR. The APR tries to show the interest rate and the 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 fees and loan costs.

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