How Amortizing Interest Can Help You Avoid a Predatory Debt Cycle

When you’re taking out a loan with bad credit, you want to make sure that every payment you make brings you one step closer to getting out of debt.

Before we get this wild and crazy party started and wax rhapsodic about the benefits of amortizing interest, we need to answer a simple question: What is a predatory debt cycle, and why is it something you’ll want to avoid?

Luckily, we don’t need to worry about the second half of that question, as just describing a predatory debt cycle will do a good job conveying the threat it poses to a person’s long-term financial stability.

A debt cycle is what happens when a person owes so much money towards their debt that they end up having to take on new debt in order to make ends meet. And while debt cycles are sometimes the result of pure financial mismanagement, a predatory debt cycle is what happens when a lender’s financial products are basically designed to trap borrowers in such a pattern.

Clearly, any kind of debt cycle is one you’ll want to steer clear of, but for folks with low incomes and poor credit scores, it’s all too easy to become ensnared by products that offer short terms and seemingly low interest rates. And one thing those products don’t have is amortizing interest.

What is amortizing interest?

When you take out a loan or a credit card, you are going to be charged interest, which is money on top of the amount that you borrowed. It’s how lenders make a profit and also how they protect themselves against the risk of borrowers not repaying. The better your credit score, the less risk you pose to a lender and the less interest you’ll be charged.

Interest is charged as a percentage of the amount borrowed—either as a flat rate or as an amount that accrues over a specific period of time. The former is common with short-term bad credit loans like payday loans, while the latter applies to pretty much all long-term installment loans and credit cards.

Interest that accrues over time is also oftentimes a part of an amortizing repayment structure! So when we talk about amortizing interest, that’s what we mean. With an amortizing loan, every payment made goes towards both the principal loan amount and the interest owed. While the first payment is mostly interest, the ratio shifts a little bit with each subsequent payment, until the final payment is almost entirely principal.

Since amortizing interest accrues over time and is calculated as a percentage of the total amount owed, this means that the amount you regularly get charged in interest will grow smaller over time. As a result, you’ll end up paying less in interest then you would initially think given the loan’s stated annual percentage rate or APR.

Here’s an example: If you took out a $1,000 one-year personal loan with a 10 percent APR, you would expect to pay $100 in interest, right? But you don’t! You would only pay $87.92 in interest. It’s not a huge difference, but every little bit counts.

The problem with non-amortizing loans.

As we mentioned above, non-amortizing loans are generally short-term products (like payday and title loans or cash advances) with average repayment terms around two weeks to a month. With such a short time to pay back a given loan, charging interest as a flat fee kind of makes sense.

But here’s the issue with short-term, non-amortizing loans. While it might seem like they would be fairly easy to pay off on-time, many people find the opposite to be true. They actually find short-term loans harder to pay off than traditional installment loans.

A lot of this comes down to the size of the payments. Simply put, these loans are usually designed to be paid back all at once, and many folks don’t have the funds to cover that kind of large transaction.

A $300 two-week payday loan with a 15 percent interest charge means making a single payment of $345. For someone on a tight budget, that’s a lot—especially in such a short time! According to a study from The Pew Charitable Trusts, only 14 percent of payday loan borrowers have sufficient funds to make their payments.

Welcome to the payday debt cycle.

So what happens when a person can’t pay back their short-term no credit check loan? Oftentimes, it’s one of two things. Either they pay the loan back and then immediately borrow another in order to cover their living expenses or they roll the loan over, paying a fee (or paying off only the interest owed) to extend the due date … and receive a new interest charge.

If that sounds familiar, it’s because it’s basically the beginning of a debt cycle! Your typical payday loan might have an interest charge of only 15 percent for two weeks, but that adds up to an APR of almost 400 percent! When the loan is paid back in 14 days, that’s not so much of a problem, but every time the loan is rolled over or reborrowed, the costs of borrowing increase.

This is the reality for many payday loan borrowers. Two separate studies from the Consumer Financial Protection Bureau (CFPB) found that eight out of 10 payday loans are reborrowed or rolled over within 14 days, while the average payday loan borrower takes out an average of 10 payday loans annually, spending 200 days per year in debt.

Because the interest charges for these loans are not amortizing, it is all too easy for borrowers to continually throw money at their debts without getting any closer to paying them off. In some cases, payday lenders have been found guilty of only deducting interest on a customer’s loan so that the loan would automatically renew without their knowledge. If you can find a better description of predatory lending, we’d like to see it!

Find a loan with amortizing interest.

Shopping around for a loan when you have bad credit can be tough. The likelihood that you’ll run into a predatory lender is far greater than it would be for someone with a score in the 750s.

And while you should always be reading the terms of your loan agreement carefully—plus checking out the lenders’ customer reviews and BBB page—you would also do well to stick with lenders who offer amortizing repayment structures.

This generally means choosing long-term bad credit installments loans over short-term payday loans. They are loans that you’ll pay off in a series of regular payments, with each payment bringing you one step closer to being out of debt entirely.

Some lenders, like OppLoans, even report your payment information to the credit bureaus, meaning that on-time payments could help improve your score! Amortizing loans aren’t perfect—nor are the lenders who offer them—but if you’re looking to avoid a predatory debt cycle, you should definitely check one out.

One great way to avoid non-amortizing loans is to fix your credit score! To learn more about how you can improve your credit, check out these related posts from OppLoans:

What other questions do you have about borrowing money with bad credit? We want to hear from you! You can find us on Facebook and Twitter.

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The information contained herein is provided for free and is to be used for educational and informational purposes only. We are not a credit repair organization as defined under federal or state law and we do not provide "credit repair" services or advice or assistance regarding "rebuilding" or "improving" your credit. Articles provided in connection with this blog are general in nature, provided for informational purposes only and are not a substitute for individualized professional advice. We make no representation that we will improve or attempt to improve your credit record, history, or rating through the use of the resources provided through the OppLoans blog.