Understanding the Downsides of Installment Loans

Installment debts are loans on which the borrower has to make monthly principal and interest payments. The payments on these loans are structured so the borrower will pay off the entire principal balance by the end of the loan term. An installment loan may appeal to you if you like having set payments, but there are certain disadvantages to these types of debts.

Interest Rate

The federal funds rate represents the interest rate banks have to pay to borrow money from other financial institutions. This rate can change at any time, and it directly impacts prime rate, which reflects the interest rate that major banks charge creditworthy borrowers for short-term loans. Over the course of a long-term installment loan, a bank receives steady income in the form of interest payments from the borrower, while the bank's own costs may vary due to changes in the federal funds rate. If banks set installment loan rates very low, the loan income may prove insufficient to cover the bank's costs if its other expenses rise during the loan term. At the outset, interest rates on installment loans are usually higher than on variable-rate loans because variable-rate loans move up and down with prime rate.

Payments

Installment loans may not be suitable for people who are more concerned with keeping payments low rather than paying down the debt. If you buy an investment home with the intention of selling it for profit, you have little incentive to pay down the principal since you will pay off the entire loan once you sell the home. If you take out an equity line rather than an installment loan, you can make small interest-only payments while you own the home, which means you have more cash to refurbish the property. Installment loans have larger monthly payments than other types of debt because you have to pay toward the principal and interest on a monthly basis.

Principal

People concerned with paying down principal normally look to installment loans rather than lines of credit. However, during the early years of an installment loan, very little of your monthly payment goes toward reducing the principal, as the majority of your payment goes toward interest payment. As the loan term nears an end, almost all of your payment goes toward principal. If you want to pay an installment loan off early or make additional principal payments, you often incur interest penalties. By comparison, with a line of credit, you can pay off your entire loan balance at any time.

Commitment

You can finance a car, a boat or even a home with an installment loan, and, depending on the collateral involved, the loan term could last as long as 30 years. Long loan terms mean smaller monthly payments, but installment loans also mean long-term commitments. If you take out a five-year or six-year loan on an old car, you may find yourself repaying the debt long after the car's useful life has ended. You may plan on living in your current home for 30 years, but a lot can happen in just 12 months, much less three decades. Therefore, installment loans require you to make long-term commitments that you may later regret.