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May 17, 2006
Credit and Loan Categories Explained
Apart from credit cards, there are five basic categories of credit:
What Is an Instalment Loan?
An instalment loan is the typical loan you take out to finance such major purchases as a car, appliances or a new roof. It is a loan of a fixed amount that requires regular payments. These payments can be made weekly, bi-weekly, semi-monthly and/or monthly. There are two types of instalment loans: fixed-rate and variable-rate.
Fixed-Rate Instalment Loans
With a fixed-rate instalment loan, the conditions and interest rate are set for the term of the loan and payments are usually blended. That means the payments are set up as a blend of principal and interest designed to repay the loan in total by the end of the term. For example, if you borrow $5,000 at 10 percent, you'll pay a total of $500 in interest in the first year, assuming the interest isn't calculated on a declining balance. That means that over one year you'll make total payments of $5,500, or $458.33 a month.
Many financial institutions calculate the interest on your loan on the declining balance. To understand how this works, you have to look at the principal (i.e., the amount you borrowed) and the interest (the cost of the loan) as two separate payments. For example, if you borrow $5,000 at 10 percent on January 1 and your payments are $400 a month, this is how your monthly payments would be applied:
| Outstanding Balance | Monthly Interest | Monthly Payment | Applied to Principal | Principal Balance | |
| February 1 | $5,000.00 | $41.66 | $400.00 | $358.34 | $4,641.66 |
| March 1 | 4,641.66 | 38.68 | 400.00 | 361.32 | 4,280.34 |
| April 1 | 4,280.34 | 35.66 | 400.00 | 364.34 | 3,916.00 |
| May 1 | 3,916.00 | 32.63 | 400.00 | 367.37 | 3,548.63 |
| June 1 | 3,548.63 | 29.57 | 400.00 | 370.43 | 3,178.20 |
| July 1 | 3,178.20 | 26.48 | 400.00 | 373.52 | 2,804.68 |
| August | 2,804.68 | 23.37 | 400.00 | 376.63 | 2,428.65 |
| September 1 | 2,428.65 | 20.23 | 400.00 | 379.77 | 2,048.88 |
| October 1 | 2,048.88 | 17.07 | 400.00 | 382.93 | 1,665.95 |
| November 1 | 1,665.95 | 13.88 | 400.00 | 386.12 | 1,279.83 |
| December 1 | 1,279.83 | 10.66 | 400.00 | 389.34 | 890.49 |
| January 1 | 890.49 | 7.42 | 400.00 | 392.58 | 497.91 |
| February 1 | 497.91 | 4.14 | 400.00 | 395.86 | 102.05 |
| March 1 | 102.05 | 0.85 | 101.20 | 101.20 | 0.00 |
As you can see, since your principal goes down each month, the amount of interest you pay also goes down so that more of your payment goes to paying off the principal. Financial institutions calculate the interest on the declining balance from the outset, so the lender will provide you with a monthly payment amount that will pay off the loan in the term you request.
With a blended payment, you know exactly how much your payments will be each month, and how long it will take to pay off the loan so you can work the payments into your budget.
Variable-Rate Instalment Loans
Variable- or floating-rate instalment loans provide you with maximum flexibility during periods when interest rates are declining. The rate of interest charged fluctuates with changes in market conditions. For example, if you take a loan in January at 10 percent and in mid-month the interest rates fall, then the interest rate charged on your loan in February would be adjusted down to reflect the lower rate. Typically, though, the amount of your payments doesn't change. Instead, more of your payment is applied to the principal since less is needed to cover the interest.
With floating-rate loans, the interest rate is not fixed. Rather it "floats" with the prime lending rate. Prime is the lowest rate a financial institution charges its best customers — usually their corporate customers since they tend to borrow considerably high amounts than most individuals. We common folk usually pay several points above prime. The more valued you are as a customer, the lower the interest rate you'll be charged.
Be aware that with a variable-rate loan, if rates rise dramatically the monthly loan payment may not cover all of the interest since the payment was established based on interest rates in effect at the start of the loan. The interest not paid would still be owed, or you may be required to increase the monthly payment. If you choose a variable-rate loan, watch where interest rates are going and lock in when rates appear to be rising. The last thing you need is to get stuck with a loan with a variable rate going up, up, up!
What Is a Demand Loan?
This is a loan for which the lender can ask (demand) repayment at any time — referred to as "calling" the loan. However, a repayment schedule is usually established at the time the loan is granted. Payments on demand loans can be blended, fixed principal plus interest, or interest only. The interest charged usually floats.
Some people choose a "fixed principal plus interest payment" where a specified amount of principal plus the interest accrued is repaid each month. If you choose this method, the payments may not be a fixed amount each month because the interest charged may vary from month to month. Alternatively the financial institution may ask for additional payments to cover the increased interest amount if rates go up.
Susie decided to buy a partnership in a commercial property venture. A demand loan was being offered by the institution that was financing the partnership deal. Susie decided she wanted to use a "fixed principal plus interest payment" so that she would have the loan paid off within five years. She chose to pay off $500 a month in principal plus whatever interest was owed. That means she would pay off $6,000 a year in principal, plus the interest. She began by making monthly payments of $725 a month. Since interest rates went up midway during the term, she eventually had to make payments of $825 a month to keep up.
With an interest-only loan, while the monthly interest costs must be paid each month, no principal is repaid. The principal remains outstanding for the full term of the loan, and interest is calculated on the full principal each month. Some people use this type of interest calculation when they are borrowing for investment purposes and want to minimize their cash flow outlay, particularly when they wish to use the interest paid as a tax deduction for income tax purposes.
Susie's husband, Dalton, also took a share in the same commercial property venture. Dalton chose to use an interest-only loan so that his cash flow wouldn't be strapped. His payments started out at $225 a month and eventually rose to $325 a month. However, he made no payments against his principal. At the end of five years, he still owed the total principal, while Susie had her loan completely paid off. However, since Dalton was doing considerably more investing than Susie, this suited his purposes. He knew exactly how much interest he had paid each month (for tax purposes) and he could easily work the $325 payments into his cash flow.
What Is a Personal Line of Credit?
A personal line of credit (PLC) is a floating-rate loan that establishes a specific amount of credit available to you. Since the maximum credit limit available is established when the PLC is approved, you don't have to be concerned with the delays or justification associated with applying for a new loan each time you need credit. Once approved, you have immediate access to the credit line established, and can use it whenever you like for whatever you like. You are often provided with a set of PLC cheques, which you can write to access the line. So, when you go to buy that new furniture, you can simply write a cheque and the money will come from the PLC to cover it.
A PLC is "revolving credit" or "open-ended credit," like a credit card. However, unlike a credit card, you can take advantage of interest rates that are often lower than those offered on instalment and demand loans. Interest on a PLC is usually calculated daily on the outstanding balance and charged monthly. The payment amount is not fixed, but a minimum monthly payment is required. Payments are applied against the outstanding balance with no prepayment penalty so you can make a full repayment at any time.
PLCs are usually offered to customers who have established a good credit history and have proven their ability to handle credit effectively. Not everyone can get one. Many financial institutions require that you have a minimum household income of $50,000 a year to qualify. That's because a PLC is a revolving line of credit and lenders are especially cautious. When a financial institution grants you a PLC, it's a vote of confidence in your ability to handle credit. And a PLC can be a tricky form of credit to manage. The line is easy to access and payment amounts are very flexible so the line can grow quickly. Some people get PLCs for the right reasons, but use them in ways that are not really to their best advantage.
PLC are useful for a number of reasons, but instant gratification shouldn't be one of them. It cost Patsy about $693 more than necessary to carry that PLC balance. You can buy a lot for $693. And that's all after-tax dollars. She would have to earn about $1,025 at her marginal tax rate to break even. There are good reasons to borrow, and not-so-good reasons to borrow.
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