Are you caught in the payday loan trap? Each week or month, you take out a payday loan to meet expenses. But after you pay back the loan, once again, you are out of money. So you take out another payday loan, and the cycle continues.
Borrowers get stuck on the loan payment merry-go-round because payday loan rates are very high – starting at 20 times more than the rates of personal loans. So why have 11 percent of Americans taken out a payday loan? Low qualification and credit requirements. Walk into a payday loan lender’s office with identification and a recent pay stub and you can leave with cash in your hands, even if you have a very low or no credit score.
Borrowers have a much cheaper option – taking out an installment loan. Installment loans provide a number of advantages over payday loans, as well as credit cards and revolving credit lines. You can benefit from lower rates while improving your credit score.
What is an installment loan?
An installment loan is a loan paid back in equal payment amounts at regular intervals (typically monthly) over a predefined period. Examples of installment loans include your 30-year mortgage or two-year car loan. Installment loans can also be used to pay student loans, consolidate debt or pay for a house renovation or vacation.
Why choose an installment loan over other loan options?
If you want to improve your credit rating, an installment loan can help you more effectively manage your debt payments.
Term of the Loan
Installment loans typically run for a period of six months to five years, but may be for a shorter or longer period. Credit cards and revolving credit lines do not have fixed terms but do have a credit limit. If you maintain a good credit record, this limit will be automatically increased. An American with an exemplary credit rating has a credit limit of around $10,000. The average credit card balance is $6,354 and increasing (Experian). You will require discipline and good budgeting habits not to use up this credit and overextend yourself.
Borrowers on the payday loan merry-go-round, meanwhile, typically renew the loans every two weeks or month (whenever the pay check arrives to pay off the current loan). They are forced to renew because the average loan interest rate payment is more than half the principal amount borrowed, often leaving no additional funds to pay expenses for the upcoming month.
Credit Rating (FICO score)
Making regular monthly payments on an installment loan helps to build a positive credit history. Increasing your credit card or revolving credit balance, in contrast, can hurt your credit score. A high credit utilization ratio negatively effects your credit score whereas, if you do exercise discipline, low credit usage will improve your credit rating.
Installment loan rates, which vary from around 6 to 36 percent (bankrate.com), may be negotiable with your lender. The average credit card interest rate, which is 13.64 percent, while determinable by credit scores is fixed. Payday loans charge exorbitantly high interest rates ranging from 200–700 percent (CNBC.com). The borrower has more control over installment loan rates. The rates are determined by your credit rating and other factors mentioned below (see Installment Loan Terms).
The installment loan fixed monthly payment allows you to gain control of your expenses and budget. Credit cards and revolving credit lines allow you to borrow any amount up to the credit limit, and the monthly payment can also vary. A minimum monthly payment can be made, though this will result in paying more in rates and less towards the principal of the debt.
How to Reduce Your Borrowing Costs With an Installment Loan
Loan payments comprise the principal (the amount of the loan) plus rate, amortized over the period of the loan. To show how much you could save by taking out an installment loan, let’s look at the example of Sophia, a computer software sales person who has overextended her monthly income by $500 on a home renovation and vacations. Sophia needs an extra $500 a month for 6 months, or $3,000, when she will start receiving monthly sales commission payments.
- A $3,000 Installment Loan
Let’s assume the loan rate is 10 percent (the rate). Twelve monthly payments will be made over a 12-month loan period.Total Loan Amount $3,000 x 1.10 = 3,300The principal multiplied by the rate.Monthly Payment $3,300/12 = $275.The total loan amount divided by the number of payments.
- A $3,000 Credit Card Balance
Or Sophie could charge $500 a month to her credit card for six months. For simplicity, assume Sophie’s credit card balance is now $3,000 and she will make the minimum payment of 5 percent at an annual rate of 13.64 percent. Using the Credit Card Minimum Payment Calculator at bankrate.com, we get:Total Loan Amount $3,836.88Monthly Payment $150This debt would take six years and nine months to pay off.
- A $3,000 Payday Loan
Alternatively, Sophia could take out a payday loan each month for six months to cover the extra $500 in expenses. Let’s assume she pays a 400 percent rate each month – the national average payday loan rate.Total Loan Amount $3,000 x 1.40 = $4,200The principal borrowed over six months ($500 x 6) multiplied by the rate.Monthly Payment $500 x 1.40 = $700The monthly principal multiplied by the rate.
- Interest Payment Comparison
On the $3,000 principal loan balance, the rate payment on the three borrowing types would be:Installment Loan – $300 ($3,000 x 0.10)Credit Card – $836.88Payday Loan- $1,200 ($500 x 0.40 = $200 x 6 months)
How to Negotiate Lower Loan Payments
Another important advantage of an installment loan is the ability to negotiate the terms. The following terms may be negotiable.
Amount of the loan – When determining how much you want to borrow, consider the monthly loan payment that will work within your budget. Evaluate different principal and rate scenarios using a loan calculator.
Loan rate – Do not assume that the rate proposed by the lender is fixed. The rate you are charged will be influenced by your credit history and past loan history. Talk to your lender about ways in which you can lower your loan rate.
Fixed versus variable rates – Variable loan rates are tied to interest rates. If current interest rates are high, a variable rate provides an opportunity to benefit from lower payments as interest rates decline.
Repayment term of the loan – The term of installment loans can vary from a few months to 30 years. Loan rates tend to decline on a sliding scale according to the length of the loan period.
Secured loan – Lenders will offer lower rates for secured loans.
Early payment penalties – You can save on interest payments by paying off the loan early. Find out if your lender charges an early payment fee.
Application, origination and broker fees – Broker fees are sometimes hidden. The best way to avoid being hit by a broker fee is to ask upfront if one is charged.
The fixed yet negotiable terms of an installment loan can help instil discipline in your debt payment plan while accommodating your income and lifestyle. Use the 50/30/20 (needs/wants/savings) rule to ensure you can comfortably budget for the loan payment. The loan payment falls into your 50 needs allocation. An installment loan can help you improve your credit score and negotiate even better loan terms in the future.