Loans: Installment Loans and Lines of Credit
You can arrange to borrow and repay the money you need for specific expenses.
From the Lightbulb Press library (Lightbulb Library). Lightbulb has published plain-English financial education for more than 35 years.
Why this matters for business owners
Business financing uses the same building blocks as consumer loans: lump sum or line of credit, fixed or variable rate, secured or unsecured. Knowing these trade-offs makes it much easier to compare a term loan, an equipment loan, and a business line of credit side by side.
| FIXED RATE | ADJUSTABLE RATE |
| Many installment loans have a fixed rate. The interest rate and the monthly payments stay the same for the term of the loan. | An adjustable rate loan has a variable interest rate. When the rate changes, usually every six months or once a year, the monthly payment also changes. |
| Advantages • Installments stay the same • Easy to budget payments • The cost of the loan won't increase • No surprises | Advantages • Initial rate lower than fixed rate • Lower overall costs if rates drop • Annual increases usually controlled • Can be easier to qualify for |
| Disadvantages • Interest remains the same, even if market rates decrease • Initial rate higher than adjustable rate • Not always available | Disadvantages • Vulnerable to rate hikes • Hard to budget for increases • Could cost more overall |
Choosing a Term
The term of a loan is critical to the cost of borrowing. Assuming the same principal and interest rate, you always save money with a shorter term because you pay less interest, though the monthly payments are larger. What's more, some shorter-term mortgage loans offer lower rates than longer-term loans with the same principal, reducing your cost even more. But if you're concerned about being able to afford the larger payments on a shorter-term loan, paying somewhat more interest with a longer loan may be wiser than risking the possibility of default.
When you need money to buy a car, pay college tuition, fix up your home, or anything else that requires an immediate cash outlay, you are often able to borrow the amount from a lender such as a bank or a credit union. If you know how different types of loans work and the particular features they offer, you’ll be in a better position to look for the one that will be best suited for you.
Here's an example that illustrates the effect of term on three $15,000 car loans of different lengths.
In some ways, of course, all loans are alike. You borrow money, called the principal, and agree to pay it back over a specific term, or length of time, with interest. But the details of each individual loan can affect how much you can borrow and how much the loan will cost you.
- Whether it’s an installment loan or a line of credit
- Whether the interest rate is fixed or adjustable
- Whether the loan is secured or unsecured
Installment Loans
When you take an installment loan, you borrow the money all at once and repay it in set amounts, or installments, on a regular schedule, usually once a month. Installment loans are also called closed-end loans because you must pay them off by a specific date.
Secured Loans
Your loan is secured when you put up collateral, or property, to guarantee repayment. The lender can repossess the collateral if you fail to repay. Car loans, mortgages, and home equity loans are the most common types of secured loans.
Unsecured Loans
An unsecured loan is made solely on your promise to repay. If the lender thinks you are a good risk, nothing but your signature is required. However, the lender may require a co-signer, who promises to repay if you don’t. Since unsecured loans pose a bigger risk for lenders, they may have higher interest rates and stricter conditions.
Lines of Credit
A personal line of credit is a type of revolving credit, similar in many ways to a credit card. It lets you access the amount you want to borrow, up to a limit set by the lender. The credit doesn’t cost you anything until you access the line. Then you begin to pay interest on the amount you borrowed. You must repay at least a minimum amount each month plus interest, but you can repay more, or even the whole loan amount, whenever you want. Whatever you repay becomes available for you to borrow again.
Banks and credit card issuers sometimes offer lines of credit automatically to people they consider good customers. But that doesn’t mean you have to borrow if you prefer not to.
If you have a $10,000 line of credit, you have access to that money over and over, as long as you repay what you use:
$ 10,000 Line of credit
– $ 6,000 You borrow
= $ 4,000 Available credit
+ $ 1,000 You repay
= $ 5,000 Available credit
Advantages
- Only one application
- Instant access to credit
Disadvantages
- Potentially high interest rate
- Easy to borrow more than you can easily repay
[TABLE 5×4: 3 YEAR | 4 YEAR | 5 YEAR | Number of monthly payments | 36 | …]
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