Installment Loans: Are They Right For You?
The article below on installment loans is for informational purposes only and should not be construed as financial advice.
Installment loans can be an incredible tool in your personal finance arsenal when used effectively. The term might sound unfamiliar or intimidating, but you’ve probably used an installment loan before, and almost certainly know someone else who has. Student loans, mortgages, personal loans, car loans – these are all common types of installment loans.
Whether you get them at a bank, or through an online lender, installment loans can help you deal with large, lump-sum costs that you may not have been able to save for. A lot of events that push people’s finances over the cliff are usually unexpected incidents like car malfunction or medical expenses. You might default to using credit cards to cover these costs, but this can be very detrimental to your financial fitness, as we’ll discuss in this post.
Even if the costs are for something that’s planned, like evening classes or moving costs, you might not have all the money you need up front. That’s when something like installment loans can be very helpful.
What are installment loans?
Let’s make up a guy and call him Jeff. Jeff just got an awesome new job! Congratulations, Jeff. Unfortunately, it’s in a new city that’s far away, so now he needs a car. Ah, but Jeff doesn’t have enough cash to buy a car at the moment.
Jeff talks to his friend Lisa about his predicament.
Lisa offers to front Jeff $1,000 in cash, at an interest rate of 10%, to be paid off in one year. (She is not messing around.) Jeff knows he can definitely save $1,100 in a year’s time (that’s $1,000 plus $100 in interest). But Lisa doesn’t want to be paid all at once a year from now. She wants to be paid back in 12 monthly payments.
Each month, Jeff will have to pay back part of the principal (that’s the original $1,000 he borrowed) along with a payment on the interest. Jeff calculates that he would have to make monthly payments of $87.92.
But multiplying $87.92 by 12 is about $1,055, which is less than the $1,100 he previously thought he would have to pay. Because Jeff is paying off part of the principal each month, there is a smaller remaining debt balance used to calculate the interest amount.
Put more simply, the 10% interest is based on however much Jeff still owes. If he pays off part of that $1,000 early, then he owes 10% interest on a smaller amount.
#protip: Paying your loan off in bigger pieces every month cuts down on the amount of interest you have to pay, letting you pay off your debt faster.
By repaying his debt in installments, Jeff ends up paying less to Lisa. Now he can worry less about saving a big pile of cash for a single payment, and instead worry about his delightful commute to work.
Definition: An installment loan is a loan repaid by the borrower over time, with a fixed number of scheduled payments. They can vary in loan term depending on what the loan is being used for and how much is borrowed.
When an installment loan helps: 5 examples
1. Pursuing higher education
If you have federal student loans, you already have more experience with installment loans than you’d probably like.
2. Buying a house
Mortgages are just installment loans secured against houses.
Unless you are Taylor Swift, it’s unlikely you’ve got the cash necessary to buy a house outright. If you’re not feeling 22 (million dollars), mortgages end up being long-term loans (usually 30 years) so you and your installments might as well get cozy now.
3. Buying a car
Auto loans are another common example of installment loans. If you don’t have the cash to cover the upfront costs of buying a car, installment loans can help without stretching your bank account too thin.
4. Dealing with an unpredicted event
Installment loans can also help you cover unexpected costs. A parent may need assistance to pay for a surgery not covered by their HMO. Your car might suddenly stall in the middle of your morning commute!
You can’t always plan for medical and car repair bills, but they can quickly wreak havoc.
Paying those bills back in installments, as you continue to earn money working, can make otherwise painful medical expenses affordable. If you need access to credit quickly, it’s worth checking out online loans. A lot of new, alternative lenders have quick and easy applications that will allow you to get your money within days.
5. Investing in your career or yourself
Early on in your career, there will be many times when you have to invest in yourself. This might mean signing up for evening classes or coding bootcamps, or relocating to a new city for a job. Many of these expenditures will require upfront investment that you might not be able to afford right away. If these are good investments that will pay off, then you can use a personal loan (a type of installment loan) to get the capital upfront, and pay it back more slowly over time.
Installment loans can be better than other types of credit (such as credit cards) because their interest rates tend to be fixed and lower. While it might be tempting to put everything on your credit card, it’s often a wiser financial decision to compare your options and make sure that you are not paying too much in interest and fees.
Things to know about other types of loans
So those are common examples of when an installment loan might be useful for you. But how can you know that unsecured installment loans are really the best option?
1. Title loans: must offer tribute
A title loan is technically an installment loan. However, they are different from unsecured personal loans, like the kind that Upstart offers, because they are secured against your property (like your car for instance). That means if you default on the loan….the lender can take your car as payment.
Let’s return to Jeff and Lisa. If Jeff is just getting settled into his new role in his new city, and then Lisa swoops in and takes his car…that won’t exactly be ideal for his career development.
2. Credit cards: easy and expensive
Even credit cards are costly when you realize that they are actually just loans with variable interest rates.
With credit cards, it’s also harder to actually see how much you are borrowing. That can easily obliterate your ability to repay. Plenty of research demonstrates that people spend a lot more when they use credit cards, as opposed to using cash. In addition, the interest compounds, so costs can skyrocket if not paid off promptly.
There are numerous options depending on your financial needs. It’s up to you to consider and weigh them carefully, to ensure that you make the healthiest financial decision. No product will fit all scenarios or preferences but some may come with significant consequences if not managed carefully.
3. Payday loans: predatory rates
Payday loans can crush your financial soul. Payday loans are unsecured cash advances on your earnings and they are very different from most installment loans.
The cost of borrowing from a payday lender is exorbitantly high: rates on payday loans can go into the triple digits! Payday lenders are incredibly strict with repayment and fees, often trying to ensnare you into a cycle of debt so that you end up paying back staggering amounts of interest indefinitely. (John Oliver recently did a cheeky segment on payday lenders.) Unfortunately, these predatory lenders often prey on low-income borrowers who are already financially unstable.
At Upstart, we stand in stark contrast to some of the high-interest or personally risky loan types mentioned above. We use a range of factors to determine the creditworthiness of our borrowers and tailor the interest rate according to their individual factors and risk profiles. Often, we’re able to provide financing for people who would not even get approved for a loan elsewhere.
Things to consider before getting an installment loan
So this is a decision that should be made carefully. How do you go about making it?
Above all, ensure that the added cost of paying off the loan is manageable given your means.
Getting into debt that you can’t pay off is crippling, not only financially, but also mentally and emotionally.
If you’ve decided that installment loans make sense for you, here are five terms you should consider:
- The interest rate on the loan
- The time you have to pay it off
- The number and frequency of repayments
- How quickly you receive the loan
- Any additional fees or restrictions
With an installment loan, it’s particularly important to pay close attention to the length of the loan terms. Do you want to pay it off quickly or over a longer period of time? Maybe you expect serious bills over the next year for some medical treatments and want to keep your payments lower with a longer repayment period. Or maybe you are expecting a promotion soon (with a welcome boost in pay) and are sure you can afford the higher installments to clear your debt faster.
Keep in mind that while it is compelling to go for a longer time horizon since it makes each installment payment smaller, by the end of the term you may have actually paid out more money than if you took a shorter term loan. While you pay less each time, you pay a lot more times and interest accrues over a longer time horizon.
To demonstrate this, let’s return to our friends Jeff and Lisa. Imagine that Jeff gets an alternative offer from Leon who offers the same amount and interest rate ($1,000 and a 10% annual rate), but tells Jeff he can pay it back in monthly installments over three years, instead of one. That would mean monthly payments of $32.27 instead of $87.92.
Leon’s offer looks pretty great. Jeff would have to pay a fraction of what he’d be paying Lisa each month. Yet, if he looks at how much he will ultimately have to pay, Jeff might think twice. Under Lisa’s offer, Jeff will end up paying $1,055 over the life of the loan. Yet with Leon, he would end up paying $1,162. That’s close to triple the interest Jeff would pay Lisa!
#pro-tip: making smaller payments and extending the life of an installment loan can prove very costly over the long run. It is really important to consider your own individual financial position and outlook when you make this decision.
Installment loans can be a great way to get the cash you need to cover necessary expenses or invest in your long-term potential. As long as you manage how much you are borrowing and keep the installment payments within your means, these loans can significantly increase your buying power and financial well-being. That translates directly into your ability to keep you and your family financially fit!