How Installment Loans Work | NextAdvising with TIME

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Installment loans are at the origin of some of the major stages of life, buy your first home financing a car. They allow large purchases by breaking them down into numerous small payments, or installments, over periods ranging from six months to 30 years.

However, not all large purchases are suitable for installment loans. As with any type of debt, it’s important to consider all the pros, cons, and costs of applying for and paying off an installment loan.

What is an installment loan?

An installment loan is a form of financing that is repaid in almost equal increments over a period of time. It’s a very flexible form of borrowing: while some loans are for relatively small amounts over a short period of time, others can run into the hundreds of thousands of dollars, to be repaid over decades.

The two main advantages of an installment loan over credit cards or other lines of credit are in their structure. Installment loans have a set “term” or a period of time during which you must repay your debt. They also have a fixed interest rate, which will not change even if the prime rate goes up or down as the economy fluctuates. With these two items locked, you will know how much you are paying each month and how long it will take you to pay off the loan.

Installment loans are best for one-time expenses, like consolidating credit card debt or medical bills. Once your loan is funded, you will not be able to withdraw cash without requesting a new loan; you will be paid in a lump sum.

This is why it is best to use an installment loan “for a specific purpose, because once you get these funds, you will ideally want to put them (them) to work,” says Akbar Rizvi, director of loans at Spring bank.

The simplicity of repayment is also an interesting feature: “You make your payment, each month it goes down little by little, and when the term is up, you are done,” says Rizvi.

Types of installment loans

Installment loans are most often used to finance the full cost of a purchase, or part of it if you have a down payment.

The three most common types of installment loans are home loans, auto loans, and personal loans. Each will ask you to complete an application with a lender, followed by a review of your credit report and credit score, which will ultimately determine your interest rate and how much you can borrow.

While personal loans and some auto loans may not require a down payment, a mortgage loan generally requires a deposit of at least 3.5% of the purchase price.

Home mortgages

Installment mortgage loans, commonly called mortgages, cover the price of a building intended for housing. Mortgages can be used to purchase single family homes, condominiums, and many other types of housing. Since they are secured loans – backed by the property they are used to buy – the lender can repossess that property if the borrower does not repay the loan.

The most common types of installment loans are conventional mortgages, FHA loans, and VA mortgages. Each offers buyers a fixed monthly payment over a period of 15, 20 or 30 years, with a mandatory deposit of between 3.5% and 5%. While conventional and FHA mortgages are available to most buyers, VA mortgages are only offered to current military and veterans.

Auto loans

An installment car loan allows you to finance a new or used vehicle. It usually lasts between 24 and 84 months.

“If you have a 60-month auto loan, you make monthly installments, or payments, each month for 60 months, paying off that balance of what you borrowed to zero at the end of the loan,” explains David Tuyo, president of the University Credit Union in Los Angeles.

Auto loans are offered by a variety of lenders, including retail banks and credit unions. Although many car dealerships provide financing by working with lenders, you may be able to negotiate a better deal if you shop around and go directly to a lender.

A down payment isn’t always necessary, but having one will lower your monthly payment and could help you get a better interest rate. As with home loans, the vehicle can be repossessed if the borrower stops repaying the loan.

Personal loans

Personal loans are offered by various institutions and are generally unsecured, but not always. Terms can range from six to 60 months, and the amount borrowed can be as high as $ 100,000 for borrowers with excellent credit. However, most personal loans are for much smaller amounts.

The interest rate on a personal loan, as well as the maximum amount borrowed, is determined by a variety of factors, from the borrower’s creditworthiness to their income and the amount of other debts they hold.

These loans are often used to consolidate a credit card or medical debt into a lower fixed interest rate loan payable over a period of time. Personal loans can also be used to finance a large purchase, including home renovations and weddings.

Advantages and disadvantages of installment loans

Installment loans are often the only way to make a large purchase where a buyer is unlikely to have the money up front. With a fixed interest rate and payment schedule, the borrower will know how much they are accepting, how much interest they will pay over the life of the loan, and when the loan will be repaid.

While there are many reasons to consider installment loans for a large purchase, they can also have drawbacks. While they offer a way to break down a big purchase into manageable payments, the biggest question you should ask yourself is, “Can I afford this loan?” “

Benefits

  • Divide large purchases into monthly payments

  • Available to people even if they don’t have great credit (albeit with less favorable interest rates)

  • Fixed interest rate for the term of the loan

  • Clear start and end dates to repay the loan

The inconvenients

  • May come with fees, including request, origin and prepayment fees

  • Non-payment can result in repossession and negative scores on your credit score

  • Lenders may not be flexible on payments in a financial emergency

Installment loans can also come with many fees that you need to consider. These can include application fees, origination fees, or even prepayment charges for the loan.

“Instead of just looking at the monthly payment, I urge borrowers to look for hidden fees like application fees, credit file fees, late fees, or circumstances under which a rate might change,” says Carol O’Rourke, Senior Financial Coach at SHOR Financial Wellness based in New York. “It’s really important to read the fine print before signing. ”

When installment loans are secured by a physical asset, such as a house or a car, there can be even stiffer penalties if you can’t make the monthly payment. Lenders have the right to repossess your property in lieu of payment, which also causes significant damage to your credit history. Before applying for a loan, be sure to do your homework on the lender and research what your options are if you have a financial emergency.

“If an institution has thousands of complaints about loan servicing or mismanagement, or a bad reputation, but has a slightly better rate, it might be worth taking another financial institution. to make sure you have peace of mind, ”explains Tuyo.

Alternatives to installment loans

An installment loan is not the only tool available to consumers making a large purchase.

You could instead ask for a credit card. Credit cards offering a introductory period with an annual percentage rate of 0% can be useful for financing large purchases over time. You’ll want to make sure you’re able to pay off the balance before the introductory period expires if you go this route, in which case it’s actually an interest-free loan. But don’t keep a balance beyond the introductory period, or you’ll pay interest that can easily exceed 25%.

“If you’re disciplined and using it the right way, a credit card can be a great option,” says Rizvi.

Consumers might also be able to establish a personal line of credit with their lender, to draw on it if necessary. Lines of credit can be unsecured, if you have excellent credit, or secured with personal assets, such as with a home equity loan or Home equity line of credit (HELOC). With a line of credit, you withdraw the amount you need and pay it back – just like with a credit card, but at a much lower interest rate, since the credit is secured by the property. .

Is an installment loan right for your purchase?

For the major expenses of life, an installment loan can offer a lot of flexibility, but before applying for it, it is important to determine what you need the money for and if it is the right one. good option for your overall financial situation.

Most importantly, ask yourself if you really need what the installment loan is for, and after that if you can afford the monthly payments.

Tuyo explains it by distinguishing between “desirable” and “undesirable” debts.

“Desirable debt will increase your personal net worth,” he says, “whereas junk debt is unnecessary debt that does not increase your net worth. An example would be hoarding a bunch of credit cards and then using an installment loan to pay for frivolous trips. ”

But if you intend to use the loan for things like “home improvement projects, which will increase your home’s value and your equity” – or for a debt consolidation which will save you money – then an installment loan may be your best option.

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