Installment Debt
What Does Installment Debt Mean?
Debt issued with the condition of regularly occurring intervals for payment by the debtor, until the principal and interest are paid in full. Investopedia explains Installment Debt…
Generally, this type of debt provides for financing the larger items that corporations and individuals don’t have the necessary cash available to purchase.
Debt comes in a few different forms, let’s take a look at installment versus revolving debt and credit.
First, let’s take a look at the definitions:
Revolving credit is a line of credit that is made available to you for use at any time. So, this would include credit cards, HELOCs, department store cards, etc. You have some sort of limit on it, but you can use all or a part of that up to the limit as long as you would like. When you repay a portion, it means you once again have that amount available to you.
Your credit limit with revolving credit is based on your credit payment history and income. If you use your credit line, you must make monthly minimum payments to pay it back. Some revolving credit lines have an annual fee, others do not.
Revolving credit is the kind of credit people get into trouble with. It is a convenient way to borrow, but it often will become an endless pit of minimum payments and barely paying the interest, let alone the principle. Also, with revolving credit, the interest can be 18% or higher, so it is much higher then an installment credit payment.
One trick of revolving credit is that as you pay off your debt, the minimum payment is also reduced. So, this often will extend the time it takes to pay off the debt, and increases how much you end up paying in interest.
Revolving credit, does have its advantages. It is no doubt convenient, and it eliminates the need to carry a lot of cash. It is also a quick way to establish you as a creditworthy risk for future loans, say if you want to eventually buy a car or house. Another benefit is that you are sent itemized monthly statements which can be useful to you when you want to track your expenses. However, all of the advantages go out the window if you do not have the self control to only use it when needed, and comparison shop first.
Installment debt is the kind of debt you get into with a big ticket purchase such as a home or a car. It is a debt where you take out a specific loan amount, and you have an interest rate on it, a term for repayment of the loan, and the payment is amortized so that you pay equal payments over the life of the loan.
Installment debt offers lower interest rates and an amortizing repayment schedule, which means that you spend a lot less then you would buying the same thing with revolving credit.
Let’s just look at an example. Let’s say you get an installment debt loan for $2,500 and your twin gets a revolving debt loan for $2,500.
Because yours is installment, your interest might be 8% or 9%, but let’s say 10% for the sake of being as accurate as possible.
Your twin has an interest 18.5% on their credit card.
Your installment loan sets up an amortization schedule for you to repay your debt in 4 years.
Your twin, making the minimum payment would spend 30 years paying off the same debt.
You would pay $544 in interest over the life of the loan.
Your twin would pay $6,500 in interest over the life of the loan.
As you can see, installment debt has its advantages.
Obviously for something like groceries, and little things you intent to pay off at the end of each month with your paycheck, getting an installment loan makes no sense. But for cars, houses, or any purchase that exceeds you monthly income, installment debt is the best debt option, even if it does not offer the same flexibility or convenience of a credit card.
A revolving line of credit, also called “open-ended credit,” is made available to you for use at any time. Examples of revolving credit are credit cards such as Visa, Mastercard, and department store cards. When you apply for one of these cards, you receive a credit limit based on your credit payment history and income. When you use the credit line, you must make monthly minimum payments based on the total balance outstanding that month. Some lines of credit will also have an annual account fee.
While revolving credit is a convenient way to borrow, it can also become an endless pit of minimum payments that barely cover the interest due. Many cards charge annual rates of interest of 18% or higher. As you pay off your debt, the minimum payment is also reduced, thus extending your payoff period and, consequently, the interest you pay. Paying just the minimum due on a $2,000 credit card loan could mean making monthly interest payments for 10 or more years!
Revolving credit, in addition to being convenient, eliminates the need to carry a lot of cash and can help establish you as a creditworthy risk for future loans. The itemized monthly statements also can help you track your expenses. But some people can easily yield to the temptation that the convenience of credit cards offers. Impulse buying, failing to compare costs, and purchasing large items you can’t afford are all downfalls brought on by always available purchasing power. Spending more than you earn in any given period is a dangerous practice at best, but doing it over an extended period of time can be financial suicide.
Installment Debt vs. Revolving Debt
Lower interest rates and an amortizing repayment schedule can make installment debt a much cheaper alternative to revolving credit.
Installment Revolving
Beginning Balance $2,500 $2,500
Interest Rate 10% 18.5%
Years to Repay 4 30*
Interest Cost $544 $6,500
*Paying 2% minimum monthly payment.
Sources and Costs of Debt
Source Type of Debt Cost
Banks and Credit Unions Personal, secured Low
Personal, unsecured Moderate
Mortgage Low
Credit Card Low to High
Mortgage Companies Mortgage Low
Department Stores Revolving High
Insurance Companies Personal, unsecured High
Related posts:
