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What Is An Installment Loan?

7-minute read

If you’ve ever financed a car, taken out a mortgage loan or are now paying back student loans, you already know what installment loans are, even if you’ve never heard that exact term.

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. Instead, that lump sum payment goes to a lender. If you take out a mortgage to buy a house, that’s an example of an installment loan. But instead of you getting the hundreds of thousands of dollars you might borrow, your mortgage lender gets the money. You then pay this money back each month with interest.

Installment loans come with different terms. A mortgage loan could come with a repayment period of 30 years or more. The term with a smaller personal loan might only be 5 years.

Installment loans are different from revolving credit. Revolving credit features a credit limit set by a lender or financial institution. You can then continue to borrow against this limit as often as you like, paying back, with interest, only what you borrow. 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 only borrow up to that much, but you only pay back what you borrow.

Types Of Installment Loans

The term “installment loan” actually covers a wide range of loan types.

Mortgage loans

Most people can’t afford to buy homes with cash, so they take out mortgage loans. These are some of the larger installment loans people can take out, with borrowers often applying for mortgages of $200,000 or more to buy their homes, and then paying the loan back each month. One of the more common types of mortgages is the 30-year version, meaning 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 depending on the strength of borrowers’ credit scores. Mortgage loans tend to come with lower interest rates. As of early 2020, it was possible for borrowers with strong credit scores to qualify for a 30-year, fixed-rate mortgage with an interest rate under 4%.

But because these loans come with such long terms, borrowers do pay a significant amount of interest over time. Say you take out a $200,000, 30-year, fixed-rate mortgage with an interest rate of 4%. If you held onto that loan for the full 30 years, you'd pay more than $140,000 in interest.

Auto loans

Buying a car can be expensive, too. That’s why so many people finance their vehicle purchases with car loans. These installment loans work in much the same way as a mortgage does: Borrowers take out a loan with interest to cover the cost of their new car. They then pay back this loan in monthly installments, with interest.

Terms, though, are shorter with auto loans. Borrowers can take out car loans with 3-year repayments, for instance. But they can go longer, too. Financing companies do offer car loans with terms of 5, 6 or 7 years. Be careful, though: The longer the term, the more interest you will pay over time.

Personal loans

Personal loans are money that 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 higher credit scores will get lower rates.

Personal loans are usually unsecured. This 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 a personal loan, there is no collateral and nothing for lenders to take possession of if borrowers miss their payments. Because of this higher risk, the interest rates on personal loans are usually higher.

Student loans

A student loan is a loan designed to help students pay for the cost of their college education. Students can use the money from these loans to pay for tuition, room and board, books and other education-related expenses.

Student loans differ from other installment loans, though, when it comes to repayment. Borrowers usually don’t have to start repaying their student loans until 6 months have passed since their graduation.

There are two main categories of student loans: private and federal. With federal student loans, students borrow money directly from the federal government. Private student loans are offered to students or their parents from private companies. Federal student loans are more desirable because they offer lower rates and better terms. Depending on borrowers’ financial situations, though, many must rely on both private and federal student loans.

Advantages Of Installment Loans

There are several advantages of installment loans:

Fixed payments: Most installment loans come with fixed interest rates, though there can be exceptions. When your interest rate is fixed, your monthly payments will remain largely unchanged, which makes it easier to budget for your payments. Again, there are exceptions. Your monthly mortgage payment might rise or fall if your homeowner’s insurance or property tax payments do the same.

Lower interest rates: Installment loans usually come with interest rates that are far lower than what you’d get with a credit card. Consider that as of late January, the average interest rate on a 30-year, fixed-rate loan stood at 3.6%, according to Freddie Mac’s Primary Mortgage Market Survey. That’s much lower than what borrowers can get with a credit card.

Lower monthly payments: Installment loans often come with longer terms. This means that the monthly payments that come with them are often smaller, and more affordable. You’ll pay less each month, for instance, if you take out a loan with a 15-year term. That’s because the payments are spread out over so many years.

A credit score boost: Making your monthly payments on an installment loan can help you build stronger credit. Just make sure to pay on time: Paying late can have the opposite result.

Disadvantages Of Installment Loans

You might not get approved: Lenders will check your credit before approving you for an installment loan. This means that if your credit is weak, you might not get approved for that loan.

You’ll pay plenty of interest if you take a long-term loan: The longer it takes you to pay off your installment loan, the more you’ll spend on interest. Your interest payments could total more than $100,000, for instance, on a 30-year, fixed-rate mortgage if you carry that loan to its full term, depending on your interest rate and the amount you are borrowing.

You could lose a valuable asset: Most installment loans are secured, meaning that borrowers have to put up collateral when taking them out. If you default on your loan, your lender can take your collateral as a form of 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 stop making your mortgage payments, your lender can take your home through the foreclosure process.

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

Installment Loans For Borrowers With Bad Credit

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

Good credit vs. bad credit: The recipe for building good credit is simple: Pay your bills on time each month and pay down as much of your credit card debt as you can. If you pay certain debts late – 30 days or more past their due dates – and run up too much credit card debt, your three-digit FICO® credit score will fall.

In general, lenders consider a FICO® score of 740 or higher to be an excellent one. If your score is under 620, lenders might be wary of loaning you money.

This doesn’t mean that borrowers can’t qualify for a mortgage, car loan or other installment loan even with lower credit scores. Just be prepared to pay a higher interest rate, something that will make borrowing money more expensive. 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, a figure that includes both your interest rate and the fees your lender charges. When shopping for a loan, compare APRs, not just interest rates.

The good news is that if you do take out an installment loan and make your payments on time, your credit score will steadily improve. That’s because your on-time payments will be reported to the national credit bureaus. Each on-time payment is a plus for your credit score.

Installment Loans Vs. Payday Loans

You might be tempted to apply for a payday loan. But installment loans are always a better financial choice.

A payday loan is a short-term loan for a small amount of money, often $500 or less. Borrowers write a postdated check for their loan amount plus a fee charged by the payday lender. The negative here is that these fees are often high. The Consumer Financial Protection Bureau says some payday lenders charge from $15 to $30 for every $100 borrowers take out.

An installment loan such as a personal loan is always the smarter move. The costs of a personal loan are lower, and the repayment terms are spread out over a longer period. You can also borrow more money through a personal installment loan.

Summary

Installment loans are good choice whether you need to finance a big purchase such as a home or car or if you simply need extra cash in the form of a personal loan. These loans come with lower interest rates and a reliable payment schedule, making it easier to budget for your monthly payments.

Remember, though, that not paying an installment loan could hurt your credit score and might even lead to you losing your car or home. Installment loans, then, are a good choice when you need to borrow money. Just make sure you can make those payments on time.

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