Installment Loans: More Mileage for Your Money (Part 3 of 3)
In the world of lending, especially for people who have less-than-stellar credit scores, a payday loan is like a racecar: expensive and dangerous. Payday loans, with their high Annual Percentage Rates (APRs) and debt-trap structure, cause the average payday loan customer to take out ten loans per year and spend almost 200 days of the year in debt. Looks like they’re not so “short-term” after all!
An installment loan, on the other hand, is more like the family car: safe and functional, it gets the kids to school, you to work, and you can rely on it year round.
The Payday Way is a Dead End.
Let’s say your car breaks down on the way to work, and you need $1,000 in a hurry to pay for repairs. You take out a 14-day payday loan that costs $15 per $100 borrowed. The total cost of the loan is $150, and full repayment ($1,150) is due in two weeks.
But is $1,150 something you could actually pay back in two weeks? Probably not. In fact, most payday loan customers can only afford roughly $100 per month towards their loan. So you roll the loan over and pay the $150 you owe in interest in order to secure a two-week extension. However, those two weeks means paying another $150 in interest. Your payday loan now costs $300 and you still owe $1,150 to the lender. Basically, you’re right back where you started.
Let’s say it takes you six months to finally pay the loan back in full, having rolled it over 13 times. It would have cost you $1,950 in total. After half a year, you’ve ended up paying nearly twice what you originally borrowed in fees and interest alone! Payday loans might not seem disastrous in the short term, but over time their costs really add up. The APR for a 14-day payday loan that costs $15 per $100 borrowed would be an astronomical 390%. You can read more in the eBook How to Protect Yourself from Payday Loans and Predatory Lenders.
Long-Term Installment Loan = Long-Term Savings
Now what if you take out a $1,000 installment loan to pay your mechanic’s bill instead? It’s a six-month loan, with six monthly payments, and an Annual Percentage Rate (APR) of 99%. Right away, you see a huge difference in cost. Whereas the payday loan cost $1,950 over six months, this installment loan costs $307.75. That’s over six times less.
This lower cost is due to a couple of different factors. One of them is the APR. The installment loan’s 99% APR is much lower than the payday loan’s 390% APR, which means that the installment loan is less expensive. APR measures the cost of a loan over a full year, so it doesn’t matter as much when a loan is only two weeks long. But when a loan lasts for six whole months? It matters a lot. Also see What’s the Difference Between a Payday Loan and an Installment Loan? in our Blog for more information.
But there’s another factor at work that makes the installment loan even cheaper: it’s called “amortization”, and it’s not nearly as complicated as it sounds.
Amortization: The Electric Car of Personal Lending
Amortization is a specific type of loan repayment structure. Amortized loans are designed to be repaid in a series of regularly scheduled, equally sized payments. Each payment also consists of two parts: one part pays down the principal, and the other part pays down the interest. Why is that important? Because it means that every payment you make reduces the amount you owe.
Every time you reduce the principal amount owed on an amortized loan, you also reduce the amount charged in interest. With an amortizing installment loan, interest is charged as a percentage of the principal. If the principal is smaller, than the interest charge is smaller as well. The difference from one payment to the next may be small, but it adds up over time.
Installment loans are amortizing, while payday loans are not. That’s why installment loans are so much less expensive. From the first payment you make on your installment loan, you’re reducing the amount you owe. With a payday loan, on the other hand, the interest is a flat fee based on the original amount loaned. Every time the loan is rolled over, you’re being charged that same fee all over again.
Installment loans get cheaper over time; payday loans only get more expensive. Choosing between the two is just like choosing between a minivan and an F1 racecar: it’s not really a choice at all. It’s just common sense.
- Payday Loans and Deposit Advance Products. (2013, April 24). Retrieved from https://files.consumerfinance.gov/f/201304_cfpb_payday-dap-whitepaper.pdf
- Bourke, N., Horowitz, A., & Roche, T. (2013, February). Payday Lending America: How Borrowers Choose and Repay Payday Loans. Retrieved from https://www.pewtrusts.org/~/media/assets/2013/02/20/pew_choosing_borrowing_payday_feb2013-%281%29.pdf