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What is an Installment Loan?
An installment loan is a type of loan or credit available for consumers to finance all sorts of expenses. It’s common for installment loans to be used to pay for a large purchase such as a car or house.
With an installment loan, lenders give borrowers a lump sum upfront. Borrowers agree to repay that amount in regularly scheduled payments -- typically in monthly installments -- over a set period of time. With installment loans, there is an end in sight to your monthly payments.
Just about all installment loans will have a fixed interest rate, which means the interest rate does not change throughout the life of the loan. Some loans -- like certain types of mortgage loans -- may have a variable interest rate.
At the beginning of the loan term, loan payments will primarily go toward paying off the interest on the amount of money borrowed, which is higher at the start of the loan. As borrowers continue to make payments, more money will go toward paying down the principal, which is the amount of the loan remaining, excluding interest.
Installment loans are personal loans that typically use factors such as your credit history and overall financial situation to determine your creditworthiness. Generally, the higher your credit score, the more favorable the loan terms will be. For example, a better credit score may result in a lower interest rate or a higher credit limit.
Common types of installment loans
Installment loans come in different varieties and amounts depending on what you’re trying to buy. Installment loans such as mortgages and auto loans require collateral. Payday loans, credit cards, and lines of credit are not considered installment loans.
Borrowers pay back car loans in predetermined installments over a fixed period of time. Credit unions, banks, online lenders, and car dealerships issue these loans to borrowers. If a borrower defaults on their auto loan, the car can be used as collateral and repossessed.
Personal loans can finance just about anything from car repairs to home improvements, medical bills to debt consolidation, or an unexpected expense. Personal loans can be unsecured or secured loans.
A secured loan uses collateral from the borrower to guarantee repayment of the loan, while an unsecured loan does not. For example, if a borrower is using a loan to purchase a home, the house can be used as collateral to repay the lender if the borrower defaults on their payments.
Borrowers repay student loans over a set amount of time. Student loans impact your credit score the same way as other types of installment loans do. Federal student loans don’t require collateral, so they would be considered an unsecured personal loan.
A fixed-term 30-year or 15-year mortgage is considered an installment loan, as the principal and interest stay the same throughout the life of the loan. With a mortgage, your home serves as collateral, making this type of loan a secured loan. If you default on your mortgage, the lender can foreclose on the property.
It’s common to have a credit check done when you’re applying for a loan or credit card, but when lenders perform a hard inquiry on your credit report, it can impact your credit score. This can cause your credit score to drop (especially if you have multiple hard inquiries over a short period of time). For most people, a single hard credit check will cause a minimal credit score decrease, but could be more significant depending on your personal financial situation. Your score is likely to bounce back from a single hard credit check if you make consistent on-time monthly payments.
By making on-time monthly payments, installment loans can help build a positive credit history. Missing a payment or making late payments can negatively impact your credit score.
Installment loans also add to your credit mix, which is the variety of debt that shows up on your credit report. They also add to your length of credit history.
Advantages of installment loans
Each type of financial product has its pros and cons, depending on your financial situation and your ability to make on-time payments. Here are some pros to using an installment loan.
With an installment loan, the same amount will be due to your lender every payment period. The interest rate won’t change throughout the loan term. You’ll know how much to budget for your repayments.
Build credit history
If you make on-time payments throughout the entirety of your loan term, installment loans can be a positive mark on your credit report (if the creditor reports loan performance to credit reporting agencies). Paying on time can show creditors that you are a trustworthy borrower because you are responsible with the credit extended to you.
Pay for large purchases
Installment loans allow borrowers to pay for expenditures they might otherwise be unable to afford. Instead of saving for years to afford a home improvement or car, you can use an installment loan to pay off these big-ticket items over time. Credit cards can also finance a large purchase, but you’ll need to pay off the expense at the end of the month to avoid accruing interest.
Installment loan terms can range from several months to several years or decades. Large expenditures like a house, car, or college tuition may require longer terms compared to a loan for an auto repair or smaller personal expense.
Drawbacks of installment loans
Not all installment loans are created equal. It’s important to be familiar with the terms of your loan and to make note of any potential drawbacks, such as the examples below:
Fixed loan amount
With an installment loan, you’re limited to a fixed lump sum. Once the loan is paid off, you’ll need to apply for a new loan if you need more cash. Revolving credit products such as credit cards don’t need to be renewed. The same credit cards can be used for years.
Some lenders may charge origination fees, late fees, prepayment penalties, and/or application fees. Find the lenders with the most favorable conditions by doing thorough research to know all of your loan options.
Some lenders that offer installment loans may charge high interest rates. Because installment loans generally take several months or years to pay off, you could end up paying a lot in interest over time. If you have bad credit, chances are you will end up paying higher interest rates.
How do you get an installment loan?
When you fill out a loan application, lenders will require you to submit your personal financial information, which they’ll use to determine your creditworthiness. Every lender has a different approval process. It’s common that your credit score, credit history, debt-to-income ratio, and proof of income will be taken into consideration.
Collect your personal documents, research lenders to find the best fit, and apply for the loan. It’s suggested that borrowers apply for one loan at a time to prevent too many hard inquiries on their credit report.
Where can you get an installment loan?
Financial institutions such as credit unions, banks, and online lenders offer installment loans. Where you choose to apply for an installment loan will vary depending on the expense you’re financing.
There is no standard type of installment loan. Every financial services provider has different offerings. For this reason, it’s best to compare loan amounts, interest rates, repayment terms, and fees to find the best loan for your financial goals.