What Is An Installment Loan?

There’s a good chance you’ve encountered installment loans, even if you’ve never used that exact term. Mortgage loans, student loans and auto loans are all examples of installment loans you’ve likely paid off or are currently paying on.

Let’s explore the finer details of how installment loans work, different types of installment loans, and the pros and cons of using an installment loan.

At A Glance: What Is An Installment Loan And How Does It Work?

With an installment loan, you borrow a lump sum of money. You then pay that money back on a monthly basis, with interest, until your entire balance is gone.

You don’t always receive the money that you borrow as you might receive it with other types of loans. Instead, that lump-sum payment typically goes straight from the lender to the individual or company you need to pay in full upfront. For example, if you take out a mortgage to buy a house, this money will go straight from your mortgage lender to the home seller and you’ll pay this money back to the lender in monthly installments plus interest.

How Long Do Installment Loans Last?

Installment loans come with different terms. A mortgage loan, for example, often has a repayment period of 30 years. The term with a smaller personal loan might only be 5 years.

Installment Loans Vs. Revolving Credit

Installment loans are different from revolving credit. Revolving credit features a credit limit set by a lender or financial institution. You can borrow against this limit as often as you’d like, paying back – sometimes with interest – only what you borrow. However, if you pay your balance in full by its due date instead of just making the minimum monthly payment, you won’t face any interest charges. It’s only when revolving credit debt carries over from one month to the next that interest comes into play.

The most common example of revolving credit is a credit card. You might have a credit card with a credit limit of $5,000. You can borrow up to that much, but you only pay back the portion of the credit limit you actually use.

Types Of Installment Loans

Several common types of installment loans exist. Here are some examples that may already be familiar to you.

Mortgage Loans

Most people can’t afford to buy a home with cash, so they apply for a mortgage loan. These are some of the larger installment loans available, and borrowers most often apply for mortgages in the six figures to buy a home, then pay the loan back little by little each month.

Home buyers most commonly opt for a 30-year mortgage. Borrowers will repay the loan each month over 30 years if they don’t sell their home or refinance the loan.

Lenders charge interest on these loans, with the rate varying based in large part on the strength of a borrower’s credit score and credit history. Mortgage loans tend to come with a lower interest rate than the rate with credit cards and personal loans.

However, mortgages have longer loan terms, though, which usually require borrowers to pay a significant amount of interest over time.

Auto Loans

Auto installment loans work much the same as mortgage loans: Borrowers seek a loan to cover the cost of their new car. They then pay back this loan in monthly installments, with interest.

Terms are shorter with auto loans. Borrowers can take out car loans with a loan term as short as 3 years, for instance.

But loan terms can run much longer, too. Financing companies offer car loans with terms of 5, 6 or 7 years. Be careful, though: A longer term means more interest paid over time.

Personal Installment Loans

Personal loans can be used for any purpose. These loans are usually made by private lenders and in smaller amounts. Once borrowers get their money, they repay it in monthly installments, with interest.

The interest rate borrowers pay depends largely on their credit score. Those with a higher credit score will get a lower rate.

Personal loans are usually unsecured, which means that borrowers don’t put up any collateral. With a mortgage loan, the collateral is the borrower’s house. A lender can take possession of the house through foreclosure if the borrower doesn’t pay.

With an unsecured personal loan, there’s no collateral and nothing for lenders to take possession of if a borrower misses their payments. Because of this higher risk, the interest rate on a personal loan is usually higher.

Also, borrowers typically receive all of the money at once with a personal installment loan.

Student Loans

A student loan helps students pay for college education. Students can use the money from this type of loan to pay for tuition, room and board, books and other education-related expenses.

Student loans differ from other installment loans, though, with regard to repayment. Borrowers usually don’t have to start repaying their student loans until 6 months after their graduation.

Student loans can be broken down into two main categories: private and federal. With federal student loans, students borrow money directly from the federal government. Students or their parents can get private student loans from loan companies and other financial institutions.

Federal student loans often offer lower rates and better terms. However, many borrowers must rely on both private and federal student loans to get the money they need.

Pros Of Installment Loans

Installment loans offer some important benefits for borrowers. Here are a few of the key advantages:

You’ll make fixed payments each month. Most installment loans come with a fixed interest rate, which can keep your monthly payments largely unchanged and make it easier to set your monthly budget. Some exceptions exist, though. Your monthly mortgage payment might rise or fall if your homeowners insurance or property tax payments do the same.

You might get a lower interest rate. Installment loans usually come with an interest rate far lower than you’d get with a credit card.

Lower monthly payments are likely. Installment loans often come with longer terms and more affordable monthly payments. You’ll pay less each month, for instance, if you take out a loan with a 15-year term compared to a 5-year term for the same amount. That’s because the payments are spread out over so many years.

It’s possible to get a credit score boost. Making monthly payments on an installment loan can help you build stronger credit. Just make sure to pay on time, because late payments can hurt your credit score.

Cons Of Installment Loans

When you fill out a loan application, the financial institution will evaluate your creditworthiness. Here are some possible results if you don’t have a strong credit profile.

You might not get approved. Lenders will check your credit before approving you for an installment loan. If your credit is weak, you might not get approved.

You’ll pay more interest with a long-term loan. The longer it takes you to pay off your installment loan, the more you’ll spend on interest.

You could lose a valuable asset. Most installment loans are secured, meaning that borrowers have to put up collateral. If you default on your loan, your lender can take your collateral as payment.

For instance, with an auto loan, your car is collateral. If you stop paying on your loan, your lender can repossess your car. If you quit making your mortgage payments, your lender can foreclose on your home. This is a method that ensures the lender can recoup some of their investment (AKA the loan they extend to you).

You could hurt your credit score. Paying an installment loan 30 days or more past its due date will hurt your FICO® credit score because your lender will report your missed payment to national credit bureaus Experian®, Equifax™and TransUnion®.

Installment Loans For Borrowers With Bad Credit

Lenders will run a credit check when you apply for an installment loan, whether you’re looking for a mortgage, personal loan, student loan or car loan. If your credit report is weak, though, don’t panic: It’s still possible to qualify for an installment loan.

Borrowers with bad credit may pay a higher interest rate. If you want to know how much your loan costs, look at its annual percentage rate.

This figure, usually referred to as APR, shows the true cost of your loan because it includes your interest rate and the fees your lender charges. When shopping for a loan, compare APRs – not just interest rates.

There’s good news, though: If you make on-time payments on an installment loan, you can improve your credit score. Your on-time payments will be reported to the national credit bureaus, and each payment is a plus for your credit score.

Monthly Installment Loans Vs. Payday Loans

What about a payday loan? Installment loans are always a better financial choice.

Payday loans are short-term loans for a small amount of money, often $500 or less. Borrowers write a postdated check to cover their loan amount plus a significant fee the payday lender charges. The Consumer Financial Protection Bureau says some payday lenders charge up to $15 – $30 for every $100 that borrowers take out.

The costs of a personal loan are lower, and its repayment term is typically much longer. You can also borrow more money through a personal installment loan.

Installment Loan FAQs

Here are a few questions people often ask about installment loans.

What is the meaning of installment loan?

An installment loan is a loan you take out and then pay back over time. Usually, borrowers make a payment every month while paying interest on the amount borrowed.

Do installment loans hurt my credit?

Making on-time payments toward installment loan debt can help a borrower’s credit score. Falling behind on payments, though, can harm their credit score.

What’s an example of an installment loan?

Auto loans and mortgage loans are both examples of installment loans. Borrowers use them to finance major purchases and pay the amount back over time, usually in the form of a monthly payment.

The Bottom Line: Monthly Installment Loans Can Help With Major Purchases

Installment loans are a good choice whether you need to finance a big purchase or perhaps need extra cash in the form of a personal loan. These loans come with lower interest rates and a reliable payment schedule compared to other types of financial assistance, making it easier to budget for your monthly loan payments.

Remember, though, that falling behind on payments could hurt your credit score and might even lead to you losing your car or home. Before you apply for an installment loan, be sure you can make your payments on time.

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