Loans

How are installment loans calculated?

Installment loans are one of the most common forms of credit, and they involve the disbursement of a lump sum that is repaid through a set of periodical installments that usually contain a portion of the loan’s principal plus an interest charge.

These periodical installments are usually collected by lenders every month, and the amount is determined by a set of variables associated with the loan’s credit term and interest rate.

Most Common Installment Loans

Installment loans are quite common, and some of the most popular types include:

Mortgages

In most cases, mortgages are used to purchase real estate properties, and the credit term of these loans is frequently long. Mortgages use a certain asset, typically the associated property, as collateral. If a borrower fails to pay the installments, the lender has the right to repossess the asset and sell it to recoup the outstanding debt.

Auto Loans

Auto loans are used to finance the purchase of a vehicle, and the vehicle itself typically serves as collateral. After approving an auto loan, the financial institution sends the funds to the party selling the vehicle, and the borrower must repay the loan through a set of installments. 

Personal Loans

Personal loans are the broadest category of installment loans. They include many different credit instruments, such as payday loans, debt consolidation loans, cash advances, and even installment loans granted for no specific purpose. The conditions of these loans vary widely between lenders and types of loans. They are also known as consumer loans.

What Are the Main Elements of an Installment Loan?

Various important concepts are associated with installment loans, and borrowers must understand them when they decide to apply for one. These concepts are:

Credit Term

Credit term indicates the amount of time that the borrower has to fully repay the loan’s principal plus interest. While terms are typically expressed in years, installments are typically collected every month. For longer credit terms, installments will be lower since the principal is amortized across a larger number of installments. 

Due Date

The due date indicates the exact day when the loan’s installment must be paid by the borrower. On this date, the lender will usually subtract the amount of the installment from the borrower’s bank account. Failing to make this payment on time may result in penalties that will negatively impact the borrower’s credit report.

Grace Period

A grace period typically has two different meanings. It either refers to a certain number of months that the borrower won’t have to pay installments. Or, if the borrower is late with an installment, it can refer to a number of days after the due date that the borrower can still pay the installment without penalty. If the borrower fails to pay the installment before the grace period ends, a late payment penalty may be applied.

Interest Rate

The interest rate is the percentage of interest charged on the loan’s outstanding balance every month. Interest rates vary depending on the borrower’s creditworthiness, market conditions, the type of loan, and any collateral. Additionally, there are fixed-rate installment loans and variable-rate installment loans. 

APR

The annual percentage rate (APR) indicates the estimated cost of borrowing an installment loan, including all commissions, fees, and other expenses. This percentage tends to reflect the actual cost of the loan, and some of these costs include origination fees, closing fees, and flat fees.

Principal

A loan’s principal is the amount owed by a borrower at any given point during the loan’s lifetime. This principal is equal to the lump sum granted to the borrower after approval, and it progressively diminishes after each installment until reaching zero.

Interest Charge

The interest charge results from multiplying the interest rate by the loan’s outstanding balance each month. On a fixed-rate loan, the interest rate remains the same throughout the lifetime of the loan, while on a variable-rate loan, it may vary.

Amortization Schedule

An amortization schedule indicates how the loan’s principal is amortized throughout its life. It also describes how much of each monthly installment is deducted from the loan’s outstanding balance and how much is taken by the lender as interest.

Origination Fees

Lenders usually charge an origination fee as compensation for all the back-end work and the paperwork involved in approving and extending the installment loan. These fees are commonly calculated as a percentage of the loan. They are either taken from the principal, or they are added to the amount of the first installment.

Late Penalty Fees

A late penalty fee is charged if the borrower fails to pay an installment by its due date or before the grace period has ended. These fees can be calculated as a percentage of the installment, or they can be a fixed fee.

Prepayment Penalties

If a borrower decides to pay the entire balance of an installment loan, or a portion of it, before all the installments are due, a lender may charge a prepayment penalty. These penalties are disclosed in the loan agreement, and once the borrower agrees to receive the loan, they also agree to pay this penalty in the event of prepayment. Same as with late penalty fees, prepayment penalties can be calculated as a percentage of the amount prepaid or as a fixed amount. 

What’s the Difference Between Installment Loans and Other Loans?

Installment loans are not the only type of loan available; there are also revolving credit accounts.

Revolving credit works differently than installment loans, at least to some extent. They allow the borrower to freely subtract money from the account’s credit limit and repay it at any given time. On the other hand, an installment loan provides a one-time disbursement of the loan amount after approval.

The most common form of revolving credit is a credit card, which allows the borrower to withdraw or use funds from the card’s credit limit, and the card has a billing cycle and a cut-off date. After reaching the cut-off date, the outstanding balance becomes an installment loan with its own monthly payment.

Nevertheless, the cardholder can pay off the entire balance at once, and the credit limit is freed up again to be used at their convenience.

Calculating the Monthly Payment of an Installment Loan

The calculation of an installment loan’s monthly payment can be done through a simple mathematical formula that requires basic data.

Monthly Payment = P * ( r * (1+r)n ) / ( (1+r)n-1 )

Where:

P = the amount of the loan.

r = the applicable interest rate.

n = the number of installments.

Additionally, many loans and monthly payment calculators are available on the internet. Borrowers can easily use them to estimate not just the amount of the monthly payment associated with a certain installment loan, but also its amortization schedule, and the total amount of interest paid on the loan once it is fully repaid.

While most installment loans are calculated with the formula above, in certain situations, lenders may decide to grant the borrower certain flexibility on these payments by:

  • Waiving any principal payments for a certain number of installments, which means that the borrower will only pay the interest charge on the amount owed
  • Extending a grace period to the borrower during which the lender will not collect any installments
  • Removing any interest charges on the loan, which means that the borrower will only have to repay the principal of the loan

Bottom Line

Installment loans provide borrowers with a one-time lump sum payment that is later on repaid through a set of periodical installments. These installments can be calculated by using a mathematical formula or an online calculator that facilitates the process.