Personal Installment Loan Basics
With the meltdown of the economy in 2008 and 2009, driven by the financial markets, bad home mortgages and who knows what other kinds of loans there were, I thought it would be useful to discuss some of the basics relative to loans, principle, collateral, interest rates and installment payments.
Many people seemed to get themselves in trouble when they took on too much debt or borrowed too much. But how does the average person know when they have taken on too much debt? A good rule of thumb and somewhat conservative is that if all of your loan, mortgage and credit card payments each month add up to more than 30% of your take home salary per month, then you are flirting with disaster.
Mortgage payments are based on installment payments over the term of the mortgage and the interest rate you agreed to. Typically these are fairly low due to the long term it takes to pay them off. Personal loans such as bank loans and car loans are often based on a term of 5 years or lower and a higher interest rate. The installment payments on these loans each month can be as much as the mortgage payment even though the loan amount is much smaller. Credit card loans, especially department store credit cards carry an interest rate from 15% to as much as 28%. The term may be over 5 years, but the monthly payments are very high and are often difficult to pay off quickly, since most of your monthly payment will go towards interest payments and only a small amount to paying off the principal.
Crunching the Numbers
Let’s use and example to help illustrate how these numbers can add up. First of all assume that you make $50,000 a year. After taxes, let’s assume you are left with $40,000. Out of this amount you have to pay all of your expenses including installment payments and loans, food, clothing and entertainment and something special for a rainy day.
If you recall, we said that you should not allocate anymore than 30% of your after tax income to installment loans, so that would leave $12,000 for payments. Sounds like a lot, but it is only $1000 a month! Out of this you need to pay your mortgage ( or your rent ), loan payments and credit card payments. When we mention loan payments, this also includes any money you might owe to friends and family and last resort payday loan establishments which have some of the highest interest rates around.
For example a $100,000 mortgage amortized over 25 years at 8% would require a monthly payment of $763.21 per month. Your first reaction is probably why would we use an interest rate of 8% in our example when interest rates currently as of Jan 2010 are far below this. Well the answer is interest rates are on the rise and thay have varied from lows of approximately 4% to highs of 22% over the past 30 years. Needless to say many people suffered when the rates were so high. You can make your own assumptions, but we recommend you build in a little cushion when calculating your monthly mortgage installment payments to account for higher interest rates in the future.
With $763.21 already allocated, that leaves $236.79 for other small installment payments on loans that you may have. A car loan of $10,000 over a 5 year amortization at 8% is $203.21 per month. As you can see there is not much leeway in this particular budget. Many consumers often will take on large loans without really understanding what the monthly payments are going to be and whether they can actually pay these monthly installment payments. We have not even considered credit card installment payments in this example!
Assess Your Risk
Let’s assume that you have done your homework and you can fit all of the monthly installment payments into your budget and your good to go. During the past two years many people got caught when they lost their jobs, had their pay checks reduced as companies tried to survive. In some cases people were forced to renegotiate their mortgages. This latter issue occurs when your mortgage comes up for renewal at the end of the term. Even with low interest rates, many banks were not in a position to extend loans, were going bankrupt or the original loan was at such an attractive rate that the new interest rate was actually higher than what they were paying currently. Add to these issues and the fact that house prices began to decline and many consumers decided to just walk away and suffer the consequences of bad credit ratings ( another topic for a later blog).
The message we are trying to convey is assess your risk from outside non-controllable influences. Can you survive a job loss, increased interest rates, a decline in your salary and of course higher expenses due to inflation? What risk do you want to assume and how long can you survive before the installment loans catch up to you?
Interest Rates & Savings
During the past 12 to 18 months we have seen historic low interest rates and those that can find a mortgage are getting great deals. However many governments around the world including the US Fed are planning to increase rates in the middle of 2010. In fact commercial interest rates have already started to increase. Plan for an increase in your installment payments in all areas during 2010 and beyond and avoid going beyond your 30% ratio.
We also feel that even with all of this pressure to meet all of your obligations for installment loan payments, consumers need to set something aside for a rainy day. With at least 6 months of savings equivalent to your salary saved up, many consumers can weather situations that are beyond their control. If the past 18 months have taught us anything, it is that we must look after ourselves. By the time the government gets around to doing something it is too late for most of us.
In summary, save for a rainy day, do not allow your monthly installment payment for all loans to go beyond 30% of your take home income and spend a few hours reviewing the risk and impact of personal situations that could disrupt your financial planning. Decide what action you need to take to mitigate the risk and manage your installment loans accordingly.
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