April 12, 2024
Loans

What Is An Installment Loan? Types & How They Work


Key takeaways

  • An installment loan is a debt that gives you funds all at once that are paid off in monthly amounts, called installments, over a set time period.
  • Installment loan payments usually include interest charges that are charged over the life of the loan and may be higher for borrowers with less-than-ideal credit.
  • Every lender has different eligibility requirements and offers different installment loan products, so do your research and read the fine print before applying.

Installment loans allow you to borrow money and pay it back in equal monthly payments — usually at a fixed interest rate. They can be handy personal finance tools if you’re looking to combine multiple open-ended credit accounts like credit cards into one loan that you pay off in small, manageable chunks.

The most common type of installment loan is a personal loan, but other examples of installment loans include no-credit-check loans, mortgages and auto loans.

What is an installment loan?

An installment loan is a type of closed-end debt, which means you pay it off over a set number of years, also known as your loan term. Unlike credit cards or lines of credit, which are open-ended revolving types of credit, you can’t reuse the installment credit as you pay down the balance. If you want to borrow additional money with an installment loan, you have to apply for a new personal loan.

How does an installment loan work?

Installment loans allow individuals to borrow a predetermined amount of money, disbursed in a lump sum, that can be repaid over a set period ranging from one to 30 years. Typically, these loans come with a fixed interest rate and require regular monthly payments.

A portion of each monthly payment is applied to the principal amount borrowed, and a portion is applied to the interest on the loan. You’ll continue to make the monthly loan payments over the loan term, and the lender will close the account once the loan is paid in full, including the principal and the interest.

Unsecured vs. secured installment loans

Installment loans may be secured or unsecured. A secured loan adds a lien against an asset like a home or car. If you can’t repay the loan, the lender can take your asset as payment for any balance due. Examples of secured loans include mortgages and auto loans. The approval process for mortgages can take 30 to 45 days or longer and involve more documentation.

Personal loans and buy now, pay later loans are examples of unsecured loans. The approval process is easier and usually based on your credit scores, income and debt. Unsecured personal loans can be funded in as little as 48 hours and loan amounts are typically less than $100,000.

Types of installment loans

Installment loans come in many forms. Although they operate similarly, each type comes with different features, loan purposes and average interest rates.

Personal loans

A personal loan is a type of unsecured installment loan that is repaid in monthly installments over a fixed period at a fixed interest rate. They are available from online lenders, private lenders and credit unions with repayment terms ranging from ranging from 24 months to 60 months, with some offering terms as high as 72 months.

Loan amounts generally range between $1,000 and $100,000 are provided in a lump sum and  can be used for most purposes. Some lenders have limits on

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Pros

  • Fixed interest rate
  • Fixed monthly payments
  • Lump sum payment
  • Money can be used for various purposes
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Cons

  • Interest rates may be higher
  • Origination fees and prepayment penalties
  • Eligibility requirements
  • Higher payments than credit cards

Payday loans

A payday loan is an installment loan that doesn’t require a credit check because it’s secured by your paycheck. Often considered predatory, payday loans are intended to help consumers during an emergency or when they don’t qualify for another source of credit.

Amount limits are lower than personal loans, often capped at $500. At the same time, interest rates are often much higher than traditional loans. The short-term, high-cost nature of payday loans can keep borrowers stuck in a debt cycle for years.

When approved for a payday loan, you give the lender a postdated check for the loan amount plus any fees. The lender holds the check and gives you cash and on your next payday, the lender cashes the check you provided.

If you apply for an online payday loan, you give the payday lender online access to withdraw funds for the loan repayment from your bank account when your next paycheck is deposited.

Mortgages

Another common secured installment loan is a mortgage. The most popular mortgages require homeowners to pay back the money borrowed over the course of 15 or 30 years with a fixed interest rate. Mortgage loan amount limits are much higher than personal loans, in some cases over $1 million to finance homes in expensive neighborhoods throughout the country. Because a mortgage is backed by a home, the interest rates tend to be lower.

The mortgage process can take 30 to 60 days or longer. Lenders must prove you can repay the loan based on a review of your income, job stability, credit history, down payment savings and total debt and the type of home you’re buying.

Most mortgages are closed-end installment loans with the exception of home equity lines of credit (HELOCs). HELOCs are open-ended at the start of the loan term — usually for 10 years — and switch to closed-ended installment loans for the remaining term.

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Pros

  • Fixed interest rate
  • Fixed monthly payment
  • Long repayment timeline
  • Lower interest rates
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Cons

  • Can be harder to qualify
  • If you fail to make payments, home can be foreclosed upon
  • When including interest over 15 to 30 years, overall cost is significant

Auto loans

Car loans are another popular type of secured installment loan. Typically, consumers make a down payment on a car or apply the trade-in value of their existing car, then finance the purchase price balance with a car loan. Monthly payments are made to lenders until the car loan is paid in full.

The process is usually fairly quick if you’re buying a new car from a dealership or from an online lender. It may take longer if you purchase a used car from a private party and finance it through a bank or credit union.

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Pros

  • You don’t have to pay the full vehicle cost upfront
  • Fixed monthly payment amount
  • Loan helps to build your credit profile
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Cons

  • Good credit score is required for the best interest rates
  • If you default, the vehicle can be repossessed
  • Car depreciates over life of the loan

Student loans

There are two types of student loans — private and federal. Both are installment loans that can only be used to pay for college tuition and expenses related to attending college.

The most popular of the two are federal student loans, which generally are available to any student who needs funding and qualifies. There are no minimum credit score requirements to obtain a federal student loan and there is no credit check involved unless you’re taking out the Direct PLUS loans for parents, graduate students and professional students.

Another benefit of federal student loans is that the interest rates are standardized, meaning every borrower pays the same fixed interest rate. Unlike most private student loans, federal loan programs offer a variety of repayment benefits, including loan forgiveness programs, income-driven repayment plans. forbearance and deferment options may also be available.

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Pros

  • Federal student loans are available to any student who needs one and attends an institution listed on the FAFSA
  • No minimum credit score for federal student loans
  • Standardized and fixed interest rate
  • Forgiveness and deferment programs are available
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Cons

  • The interest could amount to tens of thousands of dollars over the life of the loan
  • Federal loans have caps on how much you can borrow
  • Repayment can take anywhere from 10 to 30 years

Buy now, pay later loans

Buy now, pay later loans are a type of short-term unsecured financing that allows you to make purchases and pay for them in interest-free installment payments. The payments are made over a specific period, which is generally a few weeks,

BNPL loans provide convenience but can also lead to overspending because they encourage you to spend more than you can repay. These types of loans also create the illusion that products or purchases are less expensive than they are.

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Pros

  • Interest-free payments
  • Makes expensive purchases more manageable
  • Easy to get approved
  • Does not impact credit score in most cases
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Cons

  • May face high interest rates if purchase isn’t paid off in time
  • Illusion that purchases are less expensive
  • Easy to get into debt
  • Down payment may be required at checkout

Pros and cons of installment loans

The benefits of installment loans are usually tied to having a predictable payment that can be spread out over a set time period to keep payments low. However, that set payment schedule may be a disadvantage if your financial situation changes or you need more money.

Pros of installment loans

Installment loans have many advantages, including:

  • Stable monthly payments: Monthly payments remain the same for the duration of the loan, making it easier to create a household budget and pay bills on an ongoing basis.
  • Credit score boost potential: Establishing a clean payment history with no late payments on an installment loan helps improve your credit score. Replacing revolving debt with an installment loan could also help reduce your credit utilization ratio, resulting in a higher credit score in the future.
  • Predictable payoff date: You can choose how quickly or how long it takes to pay off an installment loan when you choose the loan term. Because you can’t reuse the credit like a credit card, you avoid overspending, and each payment brings you one step closer to paying the debt in full.

Cons of installment loans

If you’re thinking about taking out an installment loan, make sure to consider the potential drawbacks:

  • Inflexible payments: Since installment loans deposit funds in a lump sum, you can’t increase the amount borrowed if you run into a new financial hurdle or emergency. There’s also no minimum payment option like a credit card, which puts you at a higher risk of missing a payment if your income suddenly drops.
  • Asset loss if you default: Secured installment loans like mortgages and auto loans put you at risk of losing your home or your car if you can’t repay the loan. A student loan default could result in a credit ding that makes it difficult to get a mortgage in the future.
  • More difficult approval process: It may take longer to get an installment loan than a revolving loan, especially if it’s secured. You may also have to provide more documentation and meet more stringent qualifying requirements than most revolving credit types.
  • Higher potential fees and closing costs: Because you can borrow more, installment loan closing costs may be higher than other types of credit. Personal loans may also come with origination fees, which are a percentage of the amount that’s either added to the balance you have to pay off, or subtracted from the funds you receive.

Do installment loans hurt your credit?

Installment loans can harm your credit if you’re late on a payment and or apply to several lenders that do hard inquiries to check your credit. Your scores will drop more due to a late payment than a credit inquiry, so make sure you keep your payment current.

To avoid a ding in your payment history, consider setting up automatic payments so you don’t miss a due date. Try to choose personal loan lenders that offer prequalifications without a credit pull.

Should you get an installment loan?

An installment loan makes sense if you can afford the payment, are financially stable enough to repay it and get some sort of financial benefit from it. Installment loans require a payment commitment that can last as long as 30 years. If you’re planning to change jobs, careers or anticipate ups and downs in your earnings, an installment loan may not be your best option.

Where to get an installment loan

Installment loans can be obtained through a bank, credit union or online lender, but each institution will have products, eligibility criteria and terms that vary widely from each other. You may get a rate discount or break on closing costs for an installment loan through your local bank or credit union, but they may not offer a wide variety of products.

Check out loan comparison sites that match you up with several different lenders based on the information you provide so you can compare offers side-by-side. If you’re getting a mortgage, consider mortgage brokers as well as mortgage banks and online lenders. Mortgage brokers work with a variety of different lenders to find the best program and terms for your needs.

Regardless of what type of installment loan you shop for, compare quotes from at least three different companies to make sure you’re getting the right loan at the best rate and costs.

How to get an installment loan

The process for getting an installment loan may vary depending on what type of loan you’re

applying. However, the process typically includes:

  • Deciding what type of installment loan is best: Decide if you want a secured or an unsecured loan.
  • Choosing the right term for your budget: Short-term loans come with higher monthly payments and lower rates, while long-term loans save you money each month at the expense of more interest over the life of the loan.
  • Shopping around for the best rates and terms: Not all lenders offer the same rates, and some may offer special incentives that fit your credit score, income or loan purpose.
  • Meeting the lender’s requirements: Personal, BNPL and student loans typically require less paperwork than mortgage and auto loans. Some installment loans may require paystubs, bank statements and a deeper dive into your finances, while others make the loan based on the information you fill out in the application.
  • Finalizing your loan and receiving your funds:  You’ll have cash in your pocket faster with an unsecured personal loan than a secured loan like a mortgage. Because mortgages are typically larger loans, there may be more hoops to jump through before you receive your funds.

Alternatives to installment loans

You may want to consider alternatives to installment loans if you don’t need cash right away or want more options for how you make payments each month. Revolving credit accounts like credit cards or HELOCs may also be a good option if you want to be able use and reuse your credit for ongoing costs like business inventory or fix-up repairs on house flipping investments.

  • A personal line of credit (PLOC) is a typically unsecured, revolving credit line account that has a variable interest rate. These accounts function much like credit cards. You apply for a specified amount of credit, then access the money as needed. Repayments are based on the amount of money that’s been used.Applying for a PLOC does not require collateral, such as your home. However, PLOCs are often reserved for consumers with a good credit score of 680 or more.
  • If you don’t need to borrow a lot and want the flexibility to use and reuse credit, credit cards are worth a look. There may be additional perks like travel rewards and cash back, and you can avoid interest rate charges if you pay whatever you charge by the end of your billing cycle.However, depending on your credit scores, credit card interest rates may be much higher than installment loan rates. If you max them out, your credit score could take a big hit since your credit utilization ratio is directly related to your credit card balances.
  • A home equity line of credit (HELOC) is like a credit card secured by your home’s equity. You can use the funds as often or little as you wish, pay the balance off and use it again. The line of credit draw period usually lasts 10 years before it converts to an installment loan.The drawback is your home is collateral for the home, which means you could lose your home if you can’t repay the HELOC. Or, if you need to sell your home in a hurry, you’ll make less profit if you still have a HELOC balance.

Bottom line

Installment loans are a convenient option for consumers looking to cover a large expense, unexpected financial emergency, consolidate high-interest debt or buy a car or home. But before you apply, it’s vital to understand how different types of installment loans work. It’s equally important to shop around with different lenders to find a loan product with favorable terms that works for your financial situation.



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