collage of money, charts, student working and graduating

Installment Loans Revisited

by Ryan Buttrey, PFP Student, with Robert Weagley, Chair

Have you been considering buying a car?  How do you plan to pay your tuition? Do you have many credit cards with a balance and you are looking for a way to consolidate your credit card bills into one payment? If any of these, among a myriad of other options that entice you to borrow money, are true, you are likely considering an installment loan for the money you owe. Installment loans can be an “upside down” liability or they can be a rational way to help you manage obligations where credit is your choice.  Credit is not always bad.

A common example of credit being good is credit cards.  Credit cards can be a convenient way to pay for purchases and they can provide you with many consumer protections.  They can also be expensive.  If you have positive balances on multiple credit cards and you are sincere in wanting to move to a life of less debt, one might consolidate these loans into an installment loan.  As credit cards generally carry a relatively high interest rate, a consolidation loan at a lower rate of interest might be optimal.  An installment loan can consolidate multiple loans into lower, manageable payments with a lower interest rate.  If you make the same (or greater) payment as the sum of your prior monthly payments, you will amortize the loan faster with less of a finance charge.

These loans can also be used to pay for the expenses related to education, or sudden expenses for which you have inadequate emergency funds. Loans can, after all, be a helpful tool for anyone in a financial bind. Banks are in the business of providing qualified loans to their customers – loans that are lent to bank customer for legitimate reasons, pending credit approval by a loan officer. People borrow money to pay for school, new appliances, car maintenance, to help cash flow a new business, among many other reasons. While, in general, it is foolish to borrow money for any purpose other than an investment, the risk they entail is often difficult to avoid.  Moreover, if you have something you can pledge as collateral to repay the bank, should you default on the loan, you can reduce this risk and, often, the interest charged on the loan.

It is quite common for installment loans to be used to buy vehicles, a depreciating asset. This function is very common, regardless of the fact that new cars lose value as soon as they are driven off the lot. This causes the value of the loan to be greater than the value of the car, or a loan-to-value ratio exceeding 100% of the car’s value, making the loan “upside down”.  Moreover, borrowing to purchase a depreciating asset can be a choice that helps move you further from your financial success.  Consider the following.

Assume you want to purchase an $18,000 car and borrow the price at an interest rate of 8% for 48 months.  Your monthly payment would be $439.43 and, after 48 months, you will have paid a total of $21,093 and have a depreciated car worth, if you are lucky, $11,000.  On the other hand, if you drive your existing car for four years and wait to purchase the car, that $18,000 car will cost $20,260 at a 3% rate of inflation.  If you save $413.87 per month in an account that only pays 1% per year, you will be able to purchase your new car.  That car will be worth $20,260 – not $11,000.  As such, your “automobile” assets are $9,260 greater and you have established yourself as a saver.

For an appreciating asset, like your education, borrowing money may have a substantial payoff.  We know that, on average, a family with a head who has graduated from college, in 2007, had a family income of $105,219.  On the other hand, the average family with a high school educated head had an average family income of only $51,369.  Borrowing money for a higher income can be a good use of money.

So, what should you do when you are thinking about taking out a loan?

  1. Save for the purchase, if you can. Avoid taking out a loan if at all possible but, if you must, make sure it is for an asset that will pay you back.
  2. If you must take out a loan, make a large down payment, in order to reduce financing costs.
  3. Check your credit score yearly to make sure it is accurate.  Manage it to maintain its quality.
  4. Shop around! Banks and lenders compete for your business, so the more you shop around, the best loan conditions and rate of interest are more likely to be yours.

Financial success is yours to choose.  Choosing to overuse credit or using credit for items, which depreciate in value or which may altogether lose their value (like the prom dress for the date that turns out to be a dud) is foolish.  Foolish lives next door to her cousin, Failure.  Success is on a different street.