Installment Loan

Installment Loan
An Installment Loan is a loan that is designed to be paid back over time in a series of equal, regular payments.

What is an Installment Loan?

An Installment Loan is a loan designed to be repaid over time in a series of equal, regular payments. These are generally long-term loans, meaning that their repayment term is longer than six months. The installment structure is fairly standard for most larger loans, including personal loans, mortgages, and auto loans.[1]

What is a loan and how does it work?

An installment loan is a type of loan, which means that it’s an amount of money that one person or business gives to another person or business, with the understanding that the money will eventually be paid back. In addition to the amount of money that is lent—referred to as the loan “principal”—almost all loans also come with interest.

Interest is an amount of money that the borrower owes to the lender beyond the principal. Interest serves two purposes: It allows the lender to make money off of the loan, which makes lending out money a profitable business for the lender. It also allows the lender to protect themselves from the possibility that the borrower won’t repay the loan.

With most installment loans, interest is charged as an interest rate, where the loan accrues a certain percentage of the outstanding principal amount over a certain period of time. The most common kind of interest rate is a yearly interest rate. Here’s an example: a $1,000 loan with a 10 percent interest rate would accrue $100 in interest every year that the $1,000 principal was outstanding. In addition to the simple interest rate, loan’s also come with an annual percentage rate, or APR. This rate includes things like additional fees and charges on the loan, which makes the APR a better measure of a loan’s true cost than the simple interest rate.

How do Installment Loans work?

Installment loans are designed to be repaid over a pre-determined period of time called “the repayment term.” This term could be anywhere from 6 months on a personal loan, to 30 years on a home mortgage loan.

Over the course of that term, the loan will be paid back in a series of equally-sized payments that will occur according to a regular schedule. Most often these payments occur on a monthly basis, but they can also occur on a bi-weekly, twice-monthly, or even a weekly basis. No matter what the payment schedule is, the final payment on an installment loan will pay the loan off entirely. 

Since each payment is a fraction of the total amount owed on the loan, the length of the loan’s payment term can affect the size of these payments. The longer the repayment term, the smaller the fraction that each payment represents. Simply put, the longer the term on any given installment loan, the less the borrower will owe on each individual payment.

Here’s an example: A borrower who takes out a $1,000 installment loan with a 10 percent APR and a 12-month repayment term (with 12 monthly payments) would owe $87.92 on each payment. However, a borrower who takes out an installment loan with the same terms and a 24-month repayment term (with 24 monthly payments) would owe $46.14 on each payment.

Now, that example also accounts for the amount of interest that is owed on the loan, and it assumes that the loan’s structuring is amortizing.

What is amortization?

Amortization is a repayment structure that applies to almost all installment loans. The reason amortization is so common is because it is key to ensuring that the loan is fully paid off at the end of its repayment term. Amortization means that every payment made on the loan goes towards both the principal and the interest, which ensures that every payment gets the borrower one step closer towards paying the loan off in full.[2]

To best understand the importance of amortization, it can help to look at what happens when loans aren’t amortizing. With a non-amortizing structure, a loan’s payments don’t have to go towards the principal amount loaned; the lender could apply them towards just the interest. And since those payments aren’t going towards the principal, the borrower is not actually making any progress towards paying off their loan. Many loans that do not have amortizing structures, such as payday and title loans, are considered by many to be “predatory.”

But with an amortizing structure, each payment insures that the borrower is taking another step towards paying off their loan. In fact, most of these loans come with an amortization schedule, which shows the borrower what percentage of each scheduled payment will be applied towards the principal and how each payment will reduce the amount owed.

Because each payment on an amortizing loan pays down part of the principal, it will often save borrowers money on how much interest they pay. Remember, the amount charged in interest isn’t determined by the original amount loaned, but by the remaining principal that is still outstanding. As the principal amount grows smaller, the amount of interest that accrues grows smaller, too.

What are different kinds of Installment Loans?

The installment model is very common when it comes to loans. As such, you can find installment loans pretty much anywhere! Most personal loans are installment loans, with terms typically ranging anywhere from six months to six years. The majority of auto loans are also structured as installment loans, with terms generally in the range of three to six years.

Many mortgages are installment loans too, especially home-purchase mortgages, which typically come with 15 or 30-year terms. However, mortgages can also come with non-installment or interest-only structures. With an “interest-only” mortgage, there is a period of time during which the borrower only has to make payments on the interest that’s accrued, not on the principal. Of course, payment on the rest of the loan will become due eventually, which can mean some very large payments owed towards the end of the loan’s term.[3] Any payments that come with larger-than-normal payments towards the end of a loan’s repayment term are referred to as “balloon” payments.

Mortgages and auto loans are both secured loans, which means that the borrower offers the lender a valuable piece of property to serve as collateral. If the borrower does not repay their loan, the lender can claim ownership of the collateral and sell it in order to recoup their losses. With mortgages, the collateral is real estate—oftentimes the very piece of real estate that the mortgage is being taken out to purchase. With auto loans, it’s much the same; the collateral is usually the car, truck, SUV, or motorcycle that the borrower is using the loan to purchase.

Payday and title loans are commonly structured as non-installment loans. These loans are usually short-term, with repayment terms anywhere from a week to 60 days. Repayment on payday and title loans is generally due in a single lump sum by the end of the loan’s term, a structure that many borrowers find makes these loans difficult to repay in full. When borrowers cannot repay their payday or title loan, they are usually given the option (when available under state law) to “rollover” their loan, paying only the interest owed in order to secure a new repayment term—which also means being charged additional interest and fees. These non-installment, non-amortizing payment structures are one of the primary reasons that payday and title loans are often classified as predatory loans.

References

  1. “Installment Debt.” Investopedia. Retrieved October 17, 2016 from https://www.investopedia.com/terms/i/installmentdebt.asp.
  2. “How Amortization Works” AboutMoney. Retrieved October 17, 2016 from https://banking.about.com/od/loans/a/amortization.htm
  3. “Interest Only Mortgage.” Investopedia. Accessed March 10, 2016. Investopedia.com