Installment Loans

When people think about loans, they usually refer to loans as installment loans. Installment loans involve the borrower being advanced a certain sum of money up front, which is to paid back in prescribed installments over a certain period of time.

The time that is provided to pay back the loan is called the amortization, which is the maximum amount of time the borrower has to pay back the loan without renegotiating it, in other words getting another loan to pay off this one.

The amortization schedule is based upon certain number of months or years, which together with the interest rate charged, sets the payment. The payment must be within the borrower’s ability to repay the loan, and therefore a shorter amortization can be more difficult to qualify for since the payments would be higher.

Installment loans can either be secured by collateral, for example a car loan being secured by the car, or be a demand loan. Demand loans theoretically allow the bank to demand the loan be paid in full at any time, although this is reserved for loans in serious default as banks prefer that you take your time to pay it off, and also realize that paying off the loan in full upon request will be generally beyond the means of the borrower and would be inviting default.

However, if the loan is in default and the lender does not believe that the borrower will be able to repay it in an acceptable manner, the demand for payment in full will be made, with a view to then assign this demand to a collection agency who purchases the rights to the loan from the original lender at a discount.

Choosing Between Fixed and Variable Rate Loans

Installment loans can either be open or closed. Most loans are open, meaning that there are no prepayment penalties, although not all are. Closed loans should be avoided when possible and should be taken out as a last resort only, because they can’t be paid down quicker or refinanced. Given that the rates with closed loans are typically high, this can force the borrower to pay much more interest in the end than they would have if the loan were open.

The reason why some lenders do not allow for prepayments is to maximize the interest income that they make off of them, and to also protect from the borrower finding a more suitable rate and refinancing during the life of the loan. As one’s credit improves, it is common for better rates to become available in the middle of the term of the loan, and these options should always be investigated, although you do need an open loan to be able to refinance it.

Installment loans are offered with either a fixed or floating rate. With a fixed rate installment loan, the term of the loan and the amortization will always be the same, 60 months for each for instance. Floating rate loans, or variable loans, will offer the better rate up front usually, but are subject to additional risk due to future interest rate fluctuations.

With variable rate loans, the term and the amortization usually will differ, for example with a 60 month amortization and a 12 month term. The payments will generally be constant during the term regardless of interest rate changes, with payments being reset each term.

If the lender bears this risk, as they do with fixed rate loans, borrowers are subject to a risk premium, which is why fixed rate loans tend to be cheaper. If the prime rate goes up, the interest rate of the loan will rise in turn, and this can expose the borrower to higher interest costs and higher payments over the life of the loan.

This needs to be taken well into account by borrowers when choosing between a fixed and floating rate, especially in cases where the ratios are tight and one may get into trouble if interest rates rise too much and they have chosen a variable rate loan. This could even cause the borrower to not be able to make the payments if they rise too much and lead to default.

Lenders often allow for borrowers to switch from a variable rate to a fixed rate, although if you wait until things go against you to do that, well they aren’t going to offer you the same fixed rate they did at the time the loan was granted. You will pay market rates, and if interest rates have risen, and they just about always do when people look to change their loan type, even a fixed rate may prove problematic as the payments may still be too high.

Protecting Yourself

Choosing a fixed rate is just one way you can protect yourself against defaulting on a loan you are taking out. This does not mean that going with a fixed rate is always a better choice, and there are many instances where a floating rate is best, but in situations where things are tighter or the risk of doing so is seen as high enough to worry about, reducing your risk with a fixed rate can certainly be the better option.

There is often some flexibility when it comes to choosing the amortization with a loan, where a shorter or longer amortization can be chosen. Provided that your loan is open, it’s often better to be conservative with choosing the length of time that you are allowed to repay it.

Should your financial circumstances change for the worse, having a lower payment will be welcome, as opposed to a payment you can barely make at the best of times, with your ending up with less than the best of times later.

Most people think of job loss here, the loss of income of someone in the household, but there are a number of other things that can occur which can make it more difficult to meet your obligations in paying down your loan in the timely way that the loan demands.

Being more than 30 days late on your loan payment will cause significant damage to your credit score, even if this just happens once. The damage is enough to close the doors to anything but high interest loans for a period of several years at least, so this is not something to be trifled with.

Many people don’t understand the significance of this, and you do want to exhaust all the possibilities in preventing this from ever happening, if your credit bureau is clean and you want to keep it that way.

If you’ve already had blemishes though, while more is more harmful, it’s the first one that does the most damage, much like the first dent in your car does. Another dent isn’t good, but the fact that it is dented with just one big dent is enough to make your car far less appealing to a buyer.

So, getting the payment smaller rather than larger can really help here, and it’s best to think of your loan payment as the minimum payment, where additional payments can be made whenever one wishes. This strategy allows you to pay off the loan faster without being obligated to do so.

Other Ways to Hedge Your Risk with Loans

Lenders often offer creditor insurance, which protects you against default due to things like job loss or disability, provided that the loss is according to the terms of your policy. There are always exclusions with insurance, and creditor insurance is no different, for instance if you quit your job that won’t be covered, or if you engage in excessively risky behavior and become disabled.

If you are covered though and you lose your job or become disabled and the event is insured, this insurance will make your loan payments for you while you are out of work or unable to work. While people often have some sort of coverage for these events, they never fully replace your income, and there may not be enough money for what you need plus making your loan payments.

This is called creditor insurance for a reason, as what is being insured from your perspective isn’t the loan, it’s your good credit. From the lender’s perspective, it is the loan that is insured, and they generally will encourage borrowers to take out creditor insurance, but if something happens, your loss isn’t the loan, it’s your credit rating.

Lenders do not typically account for the decision to take out creditor insurance in their being willing to approve you, and this is only offered to you after the loan is approved. There has to be a loan to protect first. Some people take out this insurance to please the lender, but that’s never the right reason, although in many cases this can simply be a wise choice to make for your own benefit.

Another way to protect yourself against default is to have another means of making the payments should you require it. This is a benefit that revolving credit has built in, and with a revolving loan, it often is not required that you make net payments on the loan for some time, pay it down in other words, depending on the amount of available credit.

This can be used to manage the risk of installment loans as well. If you have the ability to borrow your loan payments if needed and put it on a revolving product, this can certainly keep you from defaulting on the loan should you be short and unable to make the payments on time otherwise.

Even credit cards can be used for this purpose if needed. For example, if you are $100 short on your loan payment, you would put $100 worth of purchases on your credit card, and use the money you would have spent to buy this toward the loan payment.

This should of course be used responsibly, meaning only when needed, but having revolving credit available to protect you in this way certainly can be a benefit and can protect your good credit rating when called upon. This is just one reason why having a good amount of revolving credit to fall back upon when needed is a good idea.

Installment loans have the benefit of prescribing a certain payment structure, and therefore are especially a good choice for those who don’t quite have the amount of discipline they would like to have, especially the sort of people who never seem to be able to pay off revolving debt. It’s important that you be aware of the choices involved when looking to get an installment loan and then properly consider them when deciding what type and terms are best for you.