What Is an Installment Loan and How Do They Work?
An installment loan is a lump sum of money that you borrow and then pay back in fixed intervals. Installment loans are often used to finance a major purchase, like a house, car or boat, or to finance education, though you can get an installment loan for practically any reason.
If you’re wondering what an installment loan is, you’ve come to the right place. Learn more about how installment loans work, the pros and cons, and how to get an installment loan.
What Is an Installment Loan?
An installment loan is a type of loan that lets you borrow money and repay it in equal monthly payments or according to another predetermined schedule. You pay back the principal loan amount, plus interest, in fixed monthly payments until you’ve paid back the loan.
Installment loans usually have a fixed interest rate that doesn’t change throughout the life of the loan. However, some installment loans, like private student loans, have a variable interest rate that can change while you pay back the loan.
Some installment loans also charge origination fees to process your application. Depending on the type of installment loan, you may owe prepayment fees if you pay off the loan early. But if you don’t make payments according to the repayment terms or you make late payments, you could incur additional fees and hurt your credit score.
Installment loans work differently than revolving credit, like a credit card. Revolving credit, like a credit card or a line of credit, allows you to borrow money and repay it over and over again, while you make payments on an installment loan until it’s paid off in full. Payday loans are also different from installment loans in that you repay a payday loan in a lump sum instead of fixed installments.
Types of Installment Loans
Installment loans can be secured loans, which means they’re backed by collateral, or unsecured loans, which aren’t backed by collateral. Mortgages and vehicle loans are two types of installment loans that are secured. Examples of unsecured installment loans include student loans, personal loans and debt consolidation loans.
A mortgage loan is one of the most common types of installment loans that’s used to purchase a house, condo or land. Your home is the collateral on a mortgage, so if you fail to make payments, your lender can seize your property. Most mortgages are repaid at fixed interest rates over 15 years or 30 years. Your home is the collateral on a mortgage, so if you fail to make payments, your lender can seize your property.
Car loans are also installment loans that are secured loans. Because your vehicle serves as the loan collateral, it can be repossessed if you don’t make car loan payments. Repayment terms typically range from 24 months to 84 months, with the most common being 72 months.
A student loan is an installment loan, whether you’re borrowing from the federal government or a private lender. The standard repayment term for a federal student loan is 10 years. Federal student loans have a fixed interest rate. For private student loans, the repayment terms vary by lender. Private student loan interest rates may be fixed or variable.
A personal loan is a form of installment credit that you can take out for virtually any reason. You borrow a lump sum of money, then pay it off in regular intervals. Common reasons for taking out a personal loan include medical expenses, home improvement projects, debt consolidation or paying for a wedding or vacation.
Debt Consolidation Loan
A debt consolidation loan is a personal loan that you use to combine multiple debts so you have one monthly payment, often at a lower interest rate. Because more of your monthly payment goes toward the principal balance, a debt consolidation loan can reduce the time it takes to pay off debt. APRs range from 6% to 36%, depending on your credit score.
Home Equity Loans
A home equity loan, or second mortgage, is a type of secured loan that lets you borrow against your home equity. You pay it off at a fixed interest rate over a set schedule. It’s similar to a home equity line of credit (HELOC) in that both let you borrow against your home equity, however, a HELOC is a type of revolving credit that typically has a variable interest rate.
Buy Now, Pay Later Credit
Buy now, pay later services, like Klarna and AfterPay, offer a form of installment credit. You typically split the purchase price into four interest-free payments. The installment payments are billed to your debit card or credit card.
Pros and Cons of Installment Loans
Installment loans have several advantages and disadvantages you need to know about.
Installment Loan Pros
- Predictable payments. Personal loans have a fixed payment schedule and most have fixed interest rates. Because you know the amount of your monthly payments, you can work them into your budget.
- Lower interest rates. Installment loans often have competitive interest rates that are much lower than credit card interest rates, particularly if you have good credit. The best installment loans have rates as low as 2.99% APR. That’s one reason installment loans are often a good choice for debt consolidation.
- Allow you to finance major purchases. An installment loan is often the only way to borrow enough to finance a major purchase, like a home, car or boat.
- Less impact on your credit score. Taking out an installment loan hurts your credit score less compared to charging up a credit card or line of credit. Your credit utilization ratio, or the amount of open revolving credit you’re using, accounts for 30% of your credit score. You want your credit utilization to be as low as possible. Unlike revolving credit, installment credit doesn’t affect your utilization ratio.
Installment Loan Cons
- Risk of borrowing too much. Unlike a line of credit where you can borrow as much or as little as you want, with an installment loan, you have to decide how much to borrow upfront. This could lead you to borrow too much money.
- Fees. Many installment loans have fees, such as origination fees, documentation fees and prepayment fees that can add to the cost of borrowing. Missed payments can also lead to late fees and hurt your credit.
- Risk of losing collateral. Many installment loans are secured loans, meaning they’re backed by collateral. A mortgage and car loan are two examples. If you don’t make payments, you could lose your collateral.
Frequently Asked Questions (FAQs)
A personal loan is a type of installment loan. It’s typically an unsecured loan that can be used for almost any purpose. Because personal loans usually aren’t backed by collateral, they have higher interest rates compared to mortgages and auto loans. However, they often have lower rates than a credit card.
An installment loan may hurt your credit slightly in the short term, since you may lower your average age of credit and get a hard inquiry on your credit report. However, an installment loan is typically much better for your credit than making purchases on a credit card because you’re not increasing your credit utilization.
Yes, you can typically pay off an installment loan early, but check the loan paperwork to be sure you won’t face a prepayment penalty. Also, look at the interest rates of any other debts you have. Installment loans often have lower interest rates than other types of debt, like credit cards. Tackling higher-interest debt first is typically a better bet.
Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. Send your tricky money questions to [email protected].