There are many different types of loans: student loans, mortgages, car loans, payday loans, even loans from that wealthy uncle on the mainland. But they all usually fall into one of two categories: revolving credit and installment loans.
What is Revolving Credit
With a revolving line of credit, borrowers have a limit that they can borrow, use, and repay repeatedly. Credit cards are the most common types of revolving credit. Other examples are home equity lines of credit, and department store and gas cards. The available credit, the balance, and the minimum payment fluctuates depending on the money used and the amount that is repaid.
Here’s an example
Say Kai needs new tires for his the food truck he parks at Waikiki. If he purchases the tires for $1,000 with his Visa card with a maximum line of credit totalling $10,000, he would receive a bill for that amount at the end of his billing cycle. He would also have $9,000 more to spend for purchases and services before he pays any of it back.
The lender gives Kai a few different repayment options. He can pay the $1,000 from his bank account during the grace period to avoid any interest charges. He can also pay the minimum monthly payment, which is the least he needs to pay to remain in good standing with the creditors. Kai chooses to pay $400, and revolves the remaining $600 to the next month. Because he does this, he will owe $7.50 in interest on the remaining $600 if his interest rate (APR) is 15%. If he doesn’t use his card next month, he will receive a bill for $607.50.
Next month, Kai decides to pay $500 and does not use his card any more that month. He will receive a bill for $108.84 ($107.50 + $1.34 in interest).
Benefits and Risks of Revolving Credit
Revolving credit is convenient and flexible. You can use as little or as much as you want, and it is a good way to build credit history. The main problem with revolving credit is that it can cripple you financially. If Kai fails to pay for his tires the interest can compound month after month. The idea that you can buy something and pay for it later can lead some to reckless financial choices, which can cause debt to accumulate rapidly.
What are Installment Loans
Another way to get cash is with an installment loan. This is like the mortgage for that tiny bungalow Kai wants on the North Shore of Oahu, or for that new food truck for his Honolulu customers. With an installment loan he can pay a fixed monthly payment over the length of a loan term. A portion of the payment goes to pay the interest; the rest goes to pay down the principal, what Kai owes, until he doesn’t owe anything.
Here’s an example
So how does it work? Say Kai needs $10,000 to buy a new food truck. If he signs for an installment note bearing 5% interest for a period of 60 months, he’d pay $188.71 per month. Part of that would pay down the interest, part of it would pay the principal for each installment during the period of the loan term. In the first installment, he would be paying $147.05 toward his principal and $41.67 in interest. By the time the loan is paid off, he will have paid both the loan amount and $1322.74 in interest.
Benefits and Risks of Installment Loans
Installment loans are attractive because they provide a fixed monthly payment. The interest rate remains the same, regardless of how the market changes. Also, installment loans generally occur over longer periods, making the monthly payments more tenable. This would be a sound investment for Kai, given that it would grow his company, bring in revenue, and allow him a manageable payment each month.
A mortgage typically has a loan term of 15 or 30 years. The amortization, or paying off a debt at fixed intervals, becomes manageable with each installment. These types of loans are problematic when interest rates are high, or when a borrower can’t comply with the terms of the loan. The payments, the interest rate, and the term are permanent and must be met. That said, if the borrower has budgeted wisely, it is a great way to build a business or buy a home.