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Should I get an installment loan?

Peter Miller
The Mortgage Reports contributor

The world of finance is built in large measure on the installment loan. The odds are overwhelming that you have or will have an installment loan in your life. In most cases installment financing will be a good thing. It’s how you will pay for your home, car and education. In some cases you might want a personal loan. Yup, that too is an installment loan.

What is an installment loan?

An installment loan generally has several important characteristics.

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When do you get the money?

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

How long is an installment loan?

An installment loan has a set term. The length of the loan is generally determined by the purpose.

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

What type of interest do you pay?

An installment loan may have a fixed or adjustable interest rate. With a fixed rate there is one rate for the entire loan term. This also means that the monthly cost for principal and interest is the same each 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 repay the debt. However, at the same interest rate longer loans have higher interest costs than shorter loan terms. With our $7,500 loan at 10% the total interest cost will be $1,212 over three years. The interest cost will be $2,061 over five years.

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Installment loans with adjustable rates

With adjustable-rate mortgages — ARMs — interest costs can vary as the rate moves 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 pricing for 10-year treasury securities or the federal funds rate. The index may rise or fall during the loan term.

Second, there is a margin. The “margin” is a set number that does not vary during the loan term.

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

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

For an in-depth discussion of ARMs and how they work it can pay to look at the government’s 42-page guide, the Consumer Handbook on Adjustable-rate Mortgages — also known as the CHARM book.

How is installment loan interest 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.

Auto Installment Loans

Auto financing can be completely different. Vehicle financing in many states – but not all — is calculated with the Rule of 78s. The effect of this rule is to move interest costs forward to discourage loan prepayments. The state of Mississippi explains the rule this way:

The Rule of 78s 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. Under the rule, each month in the contract is assigned a value which is exactly the reverse of its occurrence in the contract. Hence, 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 elapse, the interest is earned by the lender equal to the total value of the expired months.

For example, prepaying after 2 months of a 12 month contract would result in the lender being able 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 charges.

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

Are there are charges other than interest for installment loans?

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

Instead of looking at the “interest rate” alone, shop for installment loans on the basis of 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, the financing with the steeper APR will include more loan costs and charges.

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