Definition: An installment loan is a type of debt that is repaid through a certain number of periodic payments that consist in both principal and interest portions. These disbursements are usually equal amounts.
What Does Installment Loan Mean?
These sorts of loans are frequently employed to finance large-value items such as cars, furniture or appliances. Financial institutions offer lower interest rates than consumer credit, such as credit cards, and they are granted for a specific purchase, instead of being discretionary.
The monthly installment is calculated through a financial formula, and interest rates are charged according to the monthly remaining balance. At the beginning of the loan, the interest expense will be big but it will be reduced until it gets to zero at the last payment, this mean that as the time frame of the loan advances the principal portion of the installment will grow towards the end of the loan’s life spam.
In terms of collateral, installment loans often use the item being bought as the guarantee. If a default situation occurs the bank will repossess the merchandise and this scenario will affect the client’s credit score considerably.
Example
Martina is looking to buy a new car and she already researched many alternatives that fit her budget. She only has $3,000 for the upfront payment and her bank is willing to lend her at least 80% of the car’s value, which gives her the possibility to buy a car of at least $15,000. She decided for a small SUV of an American manufacturer and the bank informed her that she will be paying a monthly installment of $287 for 48 months with an interest rate of 7% per year.
Initially, the interest expense will be around $70 but after a year it will be around $50, which is the expected behavior of such expense in this type of loan. On the other hand, after 2 years, the capital amortization of her installment will represent at least 85% of the monthly payment.
