What is an Installment Loan?

An installment loan is a type of loan or credit available for consumers to finance various expenses. Installment loans are commonly used to pay for large purchases, 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; so there is an end in sight to your monthly payments.

Most installment loans will have a fixed interest rate, which means the interest rate does not change throughout the life of the loan. However, some loans, like certain types of mortgage loans, may have a variable interest rate.

Initially, 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 remaining loan amount, excluding interest.

Installment loans are personal loans that typically use factors such as credit history and overall financial situation to determine creditworthiness. Generally, the higher the credit score, the more favorable the loan terms. 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 are trying to buy. Installment loans such as mortgages and auto loans require collateral. However, payday loans, credit cards, and lines of credit are not considered installment loans.

Auto 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 by the lender.

Personal Loans

Personal loans can finance anything from car repairs to home improvements, medical bills to debt consolidation, or an unexpected expense. Personal loans can be unsecured or secured.

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.

Student Loans

Borrowers repay student loans over a set amount of time. Student loans impact your credit score the same way as other installment loans. Federal student loans don’t require collateral, so they would be considered an unsecured personal loan.

Mortgages

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 it a secured loan. Defaulting on your mortgage can result in foreclosure by the lender.

How does an installment loan impact your credit score?

Credit checks

It’s common to conduct a credit check when you apply for a loan or credit card. However, 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 it could be more significant depending on your personal financial situation. Your score is more likely to bounce back from a single hard credit check if you make consistent on-time monthly payments.

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.

Additionally, 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 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.

Predictable payments

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

Making on-time payments throughout the entirety of your loan term can positively impact 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 responsibly paying back the credit extended to you.

Pay for large purchases

Installment loans allow borrowers to pay for expenditures they might otherwise be unable to afford all at once. 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 their interest rates are generally much higher unless you are taking out a higher-interest installment loan product, so you’ll need to pay off the expense at the end of the month to avoid accruing excessive 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 auto repair or smaller personal expenses.

Drawbacks of installment loans

Not all installment loans are created equal. It’s important to be familiar with the terms of your loan and make note of potential drawbacks, such as the examples below:

Fixed loan amount

With an installment loan, you are limited to a fixed lump sum. Once the loan is paid off, you will need to apply for a new loan. Revolving credit products such as credit cards don’t need to be renewed and can be used for years.

Fees

Some lenders may charge origination fees, late fees, prepayment penalties, and/or application fees. Find lenders with the most favorable terms by doing thorough research to explore all of your loan options.

Interest rates

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, you will likely pay higher interest rates. If you are planning to take out a higher-interest installment loan, you should carefully consider the cost and whether you can afford the payments.

How do you get an installment loan?

When you fill out a loan application, lenders will require that you submit your personal financial information to determine your creditworthiness. Every lender has a unique approval process, typically considering factors like your credit score, credit history, debt-to-income ratio, and proof of income.

Collect your personal documents, research lenders to find the best fit, and apply for the loan. It’s advisable 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 wish to finance.

There is no standard type of installment loan. Every financial service provider has different offerings. For this reason, it’s best to compare providers, loan amounts, interest rates, repayment terms, and fees to find the best loan for your financial goals.