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There are two basic types of credit: installment and revolving. An installment loan is a form of installment credit that is closed-ended and is repaid in fixed payments over a regular repayment schedule.

Some common types of installment loans are mortgages, auto loans, student loans, and personal loans. If you’re considering borrowing money, learn more about installment loans and how they work here.

What Is an Installment Loan?

An installment loan is a lump sum of money borrowed and paid back over time. Each payment is referred to as an installment, hence the term installment loan.

In contrast, revolving credit like credit cards can be borrowed, repaid, and borrowed again up to the approved credit limit.

Installment loans can be secured with collateral or they can be unsecured. Some loans may have fees and penalties. The interest rate may fluctuate, depending on whether you choose a fixed or variable rate loan.

Recommended: Personal Loan Calculator

What Is an Example of an Installment Loan?

Installment loans can have multiple uses. These include auto loans, personal loans, mortgages, and student loans.

Auto Loans

Borrowers can take out auto loans for new and used vehicles. Monthly installments average around 72 months, but shorter loans may be available.

Loans with longer terms tend to have higher interest rates. It may seem like you’re paying less because the monthly payments may be lower, but you could end up paying more over the life of the loan.

Mortgages

Mortgages, or home loans, typically have terms ranging from 10 to 30 years with installments paid back monthly. Depending on your mortgage, you’ll either pay a fixed interest rate — it won’t change throughout your loan — or variable, which can fluctuate after a certain period of time.

Personal Loans

Personal loans are more flexible types of loans in that borrowers can use them for most purposes — examples include home repairs or debt consolidation. Many personal loans are unsecured, and interest rates will depend on your credit history and other factors.

Recommended: What Is a Personal Loan?

Student Loans

Student loans help borrowers pay for their post-secondary education such as undergraduate and graduate tuition costs. They’re either federal or private, and terms and rates will depend on a variety of factors. (With private loans, you can’t access the protections of federal student loans, such as deferment and forbearance, for example.)

Some student loans have a grace period, a period after graduation during which you aren’t required to make payments. Depending on how the loan is structured, interest may not accrue. Not all student loans have a grace period, however, so it’s important to verify your repayment schedule before you finalize the loan.

Pros and Cons of Installment Loans

An installment loan may or may not be the best fit for your borrowing needs. Consider the advantages and disadvantages, so you understand what you’re agreeing to.

Pros of Installment Loans

Here are the upsides of installment loans:

Expense

Most installment loans allow borrowers to take out large amounts, helping them to cover large expenses. For instance, many borrowers can’t afford to buy a house with cash, so mortgages can provide a path to homeownership.

Regular Repayments

Installment loans tend to come with predictable payment schedules. If you take out a fixed-rate loan, your payment amount should be the same each month. Having that knowledge of when and how much you need to pay can make it easier to budget.

Plus, installment loans have a payment end date. As long as you keep making on-time payments, your loan will be paid off in a certain amount of time.

Taking a careful look at your budget to make sure you can afford the monthly payments is an important consideration.

Refinancing

You may be able to refinance your loan to a lower rate if you’ve built your credit or if interest rates go down. Refinancing may shorten your loan repayment schedule or lower your monthly payments.

There are typically fees associated with refinancing a loan, which is another thing to consider when thinking about this option.

Cons of Installment Loans

Next, consider the potential downsides of installment loans:

Not Open-Ended

Once you finalize the loan and receive the proceeds, you can’t borrow more money without taking out another loan. Revolving credit like credit cards allow borrowers to use funds continually — borrowing and repaying up to their credit limit.

Commitment

When you take out a loan, being committed to paying it down is essential. Since some installment loans can come with longer terms — think mortgages — it’s important to make sure your budget can handle the regular payment.

Charged Interest

Like other types of loans, you’ll need to pay interest on installment loans. The interest rate you’re approved for is dependent on factors such as your credit history, credit score, and others. Applicants who have a longer credit history and a credit score at the higher end of the range will most likely qualify for the most competitive rates. If you’re stuck with a higher rate because of your poor credit, you could be making larger payments and paying more in interest.

Aside from interest, you may have to pay fees to take out an installment loan. There may also be prepayment penalties if you want to pay off your loan early.

Installment Loans and Credit Scores

How you use an installment loan can affect your credit score. If a lender reports your activity related to the loan, it could affect your score in two ways:

•   Applying for a loan: A lender may want to check your credit report when you apply for a loan, which may trigger a hard credit inquiry. Doing so could temporarily lower your credit score.

•   Paying back a loan: Lenders generally report your activity to the three major credit bureaus. If you make regular, on-time payments, this positive mark on your credit report could raise your credit score. The opposite can happen if you’re behind on or miss payments.

💡 Recommended: Installment Loan vs Revolving Credit

Getting an Installment Loan

Since taking out an installment loan is a big financial commitment, you may want to consider the following best practices:

•   Shopping around: Getting quotes from multiple lenders is a good way to compare personal loans to find one that offers the best rates and terms for your financial profile.

•   Prequalifying for loans: Getting pre-qualified allows you to see what rates and terms you may qualify for without it affecting your credit score.*

•   Enhancing your borrowing profile: Check your credit report for any errors or discrepancies. Making corrections could have a positive effect on your credit score.

•   Adding a cosigner: If you can’t qualify for an installment loan on the merits of your own credit, you may consider asking someone you trust and who has good credit to be a cosigner.

Alternatives to Installment Loans

Here are a few alternatives to consider:

•   Using a credit card: If you don’t need a large sum of money or don’t know how much you’ll need to borrow, a credit card can be a smart choice. Paying the entire balance by the due date means you won’t have to pay interest. Paying at least the minimum amount due each month will keep you from incurring a late fee, but you’ll still pay interest on any outstanding balance.

•   Borrowing from your next paycheck: Some apps let you receive an advance on your next paycheck, if you meet qualifications. You agree to pay the advance back when your next paycheck is deposited into your bank account.

•   Borrowing from friends or family: Asking to borrow money can be an uncomfortable conversation to have. However, it may be an option if you can’t qualify for or would rather not take out a bank loan. Having a written agreement outlining each party’s expectations and responsibilities is a good way to minimize miscommunication and hurt feelings.

Recommended: Family Loans: Guide to Borrowing & Lending Money to Family

The Takeaway

If you’re looking for a loan, an installment loan might fit your needs. This is a loan that disburses a lump sum, which is then paid back over time. Shopping around for an installment loan is a good way to find the best rates and terms for your unique financial situation and needs.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.

FAQ

What is the meaning of installment loan?

An installment loan is a type of loan where borrowers take out a lump sum of money and pay it back in installments. Loan amounts can range from hundreds to thousands of dollars, and terms range from a few months to a few years.

What is an example of an installment loan?

Examples of installment loans include auto loans, personal loans, mortgages, and student loans.

Are installment loans bad for credit?

Making your scheduled monthly payments on time could build your credit score. On the flip side, late or missed payments can hurt your credit score.

What is the difference between a personal loan and an installment loan?

Personal loans are types of installment loans. Other types include student loans, mortgages, and auto loans.

Photo credit: iStock/Ridofranz

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

SOPL-Q425-025

Credit cards can be a convenience for daily spending or buying a big-ticket item (a new laptop or fridge), but they have downsides, too. Perhaps most notably, they have high interest rates. As of October 2025, one analysis found that the average interest rate was just over 20%. That can make paying off debt a challenge, and balances can rise steeply.

Here, you’ll learn more about how and why credit card payments can balloon as interest rates rise. You’ll also read advice on keeping your credit card in check, which can benefit your financial wellness.

How Interest Is Calculated

If you’re confused by all of the fine print that accompanies a credit card offer or the thought of an annual percentage rate (APR) calculation makes you wince, you probably aren’t the only one. To understand how rising rates can affect your credit card payment, it helps to understand a bit about how credit card interest is calculated.

•   First, there are two types of consumer loans: installment loans and revolving credit. A mortgage, student loan, or car loan are all examples of installment loans. With an installment loan, the borrower is loaned an amount of money (called the principal), plus interest to be paid back over a designated amount of time.

•   Revolving credit, on the other hand, is not a loan disbursed in one lump sum, but is a certain amount of credit to be used by the borrower continuously, up to a designated limit. A credit card is revolving credit. A borrower’s monthly payment is determined by how much of the available credit they are using at any given time; therefore, minimum payments may change from month to month.

Installment credit is sometimes easier than revolving credit to understand and calculate. First, installment loans often come with fixed rates, which means that the interest rate doesn’t change (unless you miss payments). For example, the rate on a federal student loan or a 30-year fixed mortgage won’t change, even if government-set interest rates shoot to the sun.

Revolving credit almost often has a variable rate, which means that the interest rate applied to the credit balance fluctuates.

The average rate on credit cards is quoted as an annual percentage rate, or an APR. The APR is the approximate interest rate that a borrower will pay in one year. Why approximate? The prime rate could fluctuate based on when the Fed changes the federal fund target rate.

How Credit Card Interest Rates Change

Generally, when the Fed raises the federal funds rate, it can slow economic growth because it dissuades banks from lending money — and discourages consumers from borrowing at a subsequently higher interest rate. Raising rates is also used as a technique to combat rising inflation.

While this may be a normal and natural part of an economic cycle, rising rates can be frustrating for anyone who is currently carrying a credit card balance.

In October 2025, the average credit card interest rates were falling slightly due to interest rate cuts by the U.S. Federal Reserve, but they remain near historic highs. While lower rates are helpful, small decreases in interest may not significantly impact the debt some people carry.

What Does a Rising Prime Rate Mean for Credit Card Holders?

A change in interest rates is likely to impact anyone with a variable rate on their credit card balance. When the Fed raises federal funds interest rates, it can be expected that credit card interest rates may follow. (Similarly, when rates are cut by the Fed, credit card rates often decline.)

How much would your credit card interest rate increase if the Fed raises rates? It depends on your credit card. Generally, credit cards move in sync with rate hikes, which usually happen in quarter-percent increments.

How to Combat a High Credit Card Bill

Here are some ideas for battling a high credit card bill and potentially paying less in interest over time:

1. Pay More Than the Minimum Payment

If at all possible, pay off as much of your credit card balance as you can each month. Making payments greater than the minimum amount due can help reduce your balance. The faster you can work on reducing the actual principal balance on your credit card, the less interest you’ll likely pay. If you only pay your credit card’s minimum payment, you may wind up in debt longer and spend more on interest in the long run.

2. Switch to a Balance Transfer Card

Balance transfer credit cards typically have 0% APR introductory offers lasting for several months to a couple of years. If you’re serious about getting rid of your debt, you could transfer your debt over to one of these cards and then actively work on paying off the debt while you’re not paying interest.

If you do this, make sure to look for a card that has no transfer fee. Beware: If the root of the problem is actually overspending, this will not be a good long-term solution. Sometimes, 0% APR cards have interest rates that jump up dramatically after the trial period is over. And the 0% APR may no longer apply if you make a new purchase on the card.

3. Negotiate a Lower Rate

You might be surprised to find out that a credit card rate can be negotiable. It may be worth giving your credit card company a call and seeing whether they can reduce your rate.

When talking to the person on the other end of the line, explain your situation, be kind to them, and see what happens. Again, this isn’t a permanent solution or a guaranteed outcome, but it could help give you a leg-up on the payback journey.

4. Sign up for Credit Counseling

You might benefit from professional credit counseling to help with your credit card debt. The National Foundation for Credit Counseling (NFCC) is a nonprofit organization that offers free and affordable advice for people who are struggling to manage debt on their own. If you’re unable to envision a path to paying down debt, it could be a good idea to ask for assistance.

5. Consider a Personal Loan

One tactic to consider in an environment where prime interest rates are rising is paying off credit card balances with a fixed-rate unsecured personal loan.

These are sometimes referred to as “debt consolidation loans” and allow a qualified borrower to pay off high-interest debt, such as credit cards, with this lower-rate personal loan. With a fixed-rate personal loan, the rate never changes (as long as payments are made on time), and it helps provide the borrower with a defined plan to pay off the debt.

If you decide to go this route, it’s a good idea to shop around to ensure that you’re getting a fair rate. You can get a personal or debt consolidation loan from banks, credit unions, and online lenders.

To compare estimated personal loan interest charges to credit card interest charges, you can use a tool like a personal loan calculator.

The Takeaway

When the Fed raises interest rates, credit card payments can rise as well. If credit card debt becomes an issue, you can secure a 0%-interest credit card, access credit counseling, or consider a credit card debt consolidation loan, among other options.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.

FAQ

What is the 2-3-4 rule for credit cards?

The 2-3-4 rule for credit cards is a guideline from card issuers that limits the number of new credit card applications you can be approved for over a specific time period. It restricts applicants to no more than two new credit cards within a 30-day period, three new cards within a 12-month (one year) period, and four new cards within a 24-month (two-year) period.

What is the 15/3 rule for credit cards?

The 15/3 rule is a credit card method that involves making two payments each month: a larger one about 15 days before the statement closing date plus a smaller one three days before the due date. This can help reduce your credit utilization ratio by reducing the balance reported to credit bureaus.

Is a 700 credit score rare?

A 700 credit score is not considered especially rare. It falls within the “good” range and is slightly below the average credit score in the U.S. A score of 700 is ahead of approximately 40% of consumers who have scores below 700.

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

SOPL-Q425-022

The prime interest rate is the interest rate that banks charge their best customers. It’s the lowest rate offered to individuals and corporations that are considered low risk by banks — those with good credit history who aren’t likely to miss payments or default on their loan.

But when you run into the term “prime interest rate” in your daily life (maybe you’re taking out a personal loan or applying for a mortgage), it’s pretty common to feel a little confused. To get a better handle on this financial term and know how it relates to your money, read on.

How Is the Prime Interest Rate Set?

You’ve just learned that the prime interest rate is the rate that banks charge their best customers. Take a closer look at how the prime interest rate is set, as well as how this figure fits into the larger financial landscape.

Individual banks determine their prime interest rate. While the Federal Reserve has no direct role in setting the prime rate, many banks choose to set their prime rates based partly on the target level of the federal funds rate.

The federal funds rate is the rate that banks charge each other on an overnight basis and is established by the Federal Open Market Committee.

Why do banks lend each other money? They do so in order to meet the reserve requirement, which is also set by the Federal Reserve.

This is the minimum amount of cash a bank must have in their vault or at the closest Federal Reserve bank. If one bank has excess cash, the bank has a financial incentive to lend that excess cash to a bank that has less than its federally mandated amount. The reserve requirement acts as a lending limit for banks and also ensures that they have enough cash on-hand for the start of business each day.

How Does the Prime Rate Compare?

Generally, the prime rate is about three percent higher than the federal funds rate. That means that when the Fed raises interest rates, the prime rate typically goes up as well.

Because the prime interest rate is typically aligned with the federal funds rate, it’s highly susceptible to change. How often could the prime rate change? It can shift quite a bit. Take, for instance, the fact that the prime rate was 3.25% on March 16, 2020. From that date to July 2023, it rose 11 times to 8.50%. As of October 30, 2025, the prime rate was 7.00%.

Why Is the Prime Interest Rate Important?

The prime interest rate impacts all kinds of loans, including interest rates for mortgages, credit cards, auto loans, and personal loans. Typically, banks and lenders will use the prime interest rate as a benchmark for setting interest rates for their customers. Consider some of the ways this can impact personal finance and the economy:

•  Changes in the federal funds rate and prime interest rate can impact variable rate credit cards, adjustable-rate mortgages, home equity lines of credit (HELOC), and more. The interest rates on variable loans are based on these market interest rates and therefore change over time. In fact, variable interest rates, including those on credit cards, are often expressed as the prime rate plus a certain percentage.

Unlike fixed-rate loans, monthly payments on any variable loan could change considerably from month-to-month. This is why fixed-rate loans can be a more desirable alternative than variable loans for some borrowers.

•  Though rates are largely influenced by the Federal Reserve, borrowers have little control or way of predicting the rates from year to year. Even when the Federal Reserve predicts growth, interest rates can rise due to a variety of factors, causing your monthly bill to rise with it.

•  Beyond individual borrowers, the prime interest rate also influences the financial market as a whole. A low prime rate makes it easier and less expensive to borrow loans which increases liquidity in the market.

•  Historically, when the prime rate is low, the economy grows. That’s why, if there’s a recession, rates may go down, with the goal of getting consumers and businesses to borrow again and stimulate the economy.

When the prime rate is high, economic growth slows down. For instance, recently interest rates were raised, which can nudge consumers to think twice about spending. This can lower demand and help bring down inflation’s impact.

•  The prime rate isn’t the only benchmark that banks use to inform interest rates. Banks also often use the SOFR, or Secured Overnight Financing Rate, which replaced the London Interbank Offer Rate (LIBOR). This reflects the rate that banks charge each other for short-term loans. The federal funds rate, prime interest rate, and SOFR rates generally fluctuate together. When the three rates are out of sync, this can be an indicator of an issue with the financial markets.

Recommended: How to Apply for a Personal Loan

The Takeaway

The prime interest rate is defined as the interest rate that banks charge their best customers who are considered low risk by banks. Interest rates play an important role when you are borrowing funds to finance an expense, so it pays to pay attention to them and shop around for the most favorable offer you can find.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.

FAQ

What is the prime interest rate?

The term prime interest rate refers to the interest rate that banks charge their best customers, whether they are individuals or businesses.

What is the current prime interest rate?

At the end of October 2025, the prime interest rate was 7.00%.

What is the current interest rate for the Fed?

The St. Louis Fed reported the effective federal funds rate was 4.12% as of October 27, 2025.

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

SOPL-Q425-021

If you are grappling with debt, you are not alone. The average American, for instance, is currently carrying $7,321 in credit card debt as of 2025. But that doesn’t mean you have to live saddled with owing money and being charged high interest rates.

There are ways to make debt payoff happen faster. Read on for three strategies that can help you repay what you owe ASAP.

1. Figuring Out Your Budget

The first step to solving any debt problem is to establish a budget. A budget is essentially a summary that compares and tracks your income and expenses for a period of time, typically one month. A budget also allows you to plan how much you will spend and save each month.

You’ll want to first gather all of your bank and credit card statements for the last three or more months. You can then use them to figure out your monthly income (after taxes) and also list all of your monthly expenses. (You can do this using pen and paper, a spreadsheet or a budgeting app.)

You may want to group expenses into categories (such as insurance, groceries, eating out, insurance), and also divide them into essential vs. nonessential spending. From here, you can total your average monthly income and average monthly spending, see how they line up, and then consider making some shifts in your spending.

You might consider the 50/30/20 budget as a simple way to reorganize your finances. This budget allocates 50% of your income for essentials, like rent and bills, 30% toward nonessentials or wants, and 20% for savings and debt repayment.

If you need to free up more money to put towards debt repayment, you may want to look at your nonessential spending to find ways to cut back, such as ditching your cable bill, cooking more and getting take-out less often, and canceling your gym membership and working out at home.

Decreasing discretionary spending tends to be the easiest way to generate a monthly surplus. That surplus can then be used to pay off your debt faster.

If you find that you’ve been spending more than you earn by using credit cards, you may also want to make a plan to stop using those cards while you go after lowering your outstanding debt.

2. Choosing the Right Repayment Plan

Once your budget is set up, a great next step is to list all of your debt (with amounts owed) and in order of interest rate, and then come up with a manageable plan to pay them off.

Some options that can help you pay off debt faster include:

The Snowball Method

The snowball method is where you focus on paying off your debts in order from smallest balance owed to largest.

You can do this by paying the minimum on all your debt and:

•   Then allocate any extra money you have to the debt with the smallest balance.

•   Once the smallest debt is paid off, you can take the money you were putting toward that debt and funnel it toward your next smallest debt instead.

•   You then continue the process until all your debts are paid.

The key benefit of this method is that it allows you to experience a series of small successes at the beginning. This can give you more motivation to pay off the rest of your debt.

The Avalanche Method

Another effective debt elimination strategy is the avalanche method (also known as debt stacking). With this approach, you would pay off your accounts in order from the highest interest rate to the lowest.

•   You would make the minimum payment on all of your accounts, then put as much extra money as possible toward the account with the highest interest rate.

•   Once the debt with the highest interest is paid off, you can start paying as much as you can on the account with the next high interest rate.

•   You would continue the process until all your debts are paid.

Putting Extra Cash Toward Debt-Reduction

Once you have an emergency fund (that can cover three to six months’ worth of living expenses) in place, you may want to funnel any extra income you receive right into your repayment plan in order to pay off debts faster.

That extra might be a bonus you receive at work, a tax refund, any side hustle income, or cash earned from selling items you don’t need — all of this money could go directly toward your debt payoff.

Putting this money toward your debt, instead of saving it for a new car or spending it on a vacation, can help you pay off your debt quicker so you can eventually shift your financial focus to more fun goals.

Recommended: Typical Personal Loan Requirements

3. Looking Into Debt Consolidation

Another option you may want to consider is rolling multiple debts into one payment (ideally with a lower interest rate) through debt consolidation.

This can make your debt easier to manage (because you’ll only have one monthly bill) and less expensive overall. The less you have to pay in interest, the more money you can put towards reducing the underlying debt.

•   One way to consolidate debt is to get a 0% interest balance transfer credit card and then transfer all your debts onto this card. Typically, you will have six to 24 months of no interest during which time you can pay down your debt. Just read the fine print to be clear on what interest rate you may pay on new purchases and when the interest-free period ends.

•   Another option is to get an unsecured personal loan. In this case, you would use the money from the loan to pay off your debt, then pay back the loan in installments over a set term. Typically, these loans can offer a significantly lower interest rate than what credit cards charge, but shop around and carefully review your options before signing up.

Recommended: How to Apply for a Personal Loan

The Takeaway

If you’re looking to pay off your debt faster, it’s a good idea to review and reduce your spending and then funnel any money you free up towards your debt repayment plan. The snowball or avalanche methods can help with this. Other options to pay off debt faster include investigating debt consolidation options, such as a balance transfer card or personal loan.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.

FAQ

What are the best ways to get out of debt?

Getting out of debt can involve smart budgeting and using techniques like the snowball or avalanche method to pay off the amount you owe. You might also consider a balance transfer credit card or a personal loan to help with getting out of debt.

What is the 15/3 payment rule?

The 15/3 payment rule is a credit card technique that involves making two payments every month: a larger one about 15 days before the statement closing date and a smaller one about three days before the due date. This method can help reduce your credit utilization ratio by lowering the credit card balance reported to credit bureaus.

What is a trick people use to pay off debt?

A trick people use to pay off debt is the avalanche and the snowball technique. With the avalanche method, you pay the minimum amount on all debts and funnel any excess funds toward debt with the highest interest rate to have the most impact. With the snowball method, you put the excess toward the smallest balance to show success as quickly as possible.

SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.

SOPL-Q425-024

Mutual funds are a type of investment vehicle that combine numerous types of securities in one basket. They’re similar to exchange-traded funds, or ETFs, in that way, but there are some key differences. Mutual funds can provide investors with an accessible and turnkey way to build a portfolio with a mix of assets, often with a manager watching over the fund.

The ABCs of Mutual Funds

Mutual funds are funds, or a basket of different securities, that are packaged together and sold, in shares or fractional shares, to investors.

Mutual funds were designed for people to get started investing with smaller amounts of money. You can think of them as suitcases filled with different types of securities, such as stocks and bonds. Buying even one share of the fund immediately invests you in all the individual securities the fund holds.

The primary benefit of mutual funds is a degree of portfolio diversification. Say you invest in a mutual fund that holds stocks of every company in the S&P 500. If one company in the S&P 500 goes bankrupt, your fund might lose some value, but you probably won’t lose everything. But if your whole investment was in that one company’s stock, you’d lose all or most of your money.

How Mutual Funds Work

A mutual fund itself is actually a company that pools investors’ resources and invests it on their behalf. They create a fund of many different investment types, and manage it on behalf of the group of investors.

Mutual funds can be actively or passively managed. Passively managed funds attempt to track an index, such as the Russell 2000 (an index of 2,000 small-cap U.S. companies). In other words, if one company leaves the index and another one joins, the fund sells and buys those company’s stocks accordingly. The risk and return of these funds is very similar to the index.

Actively managed mutual funds attempt to beat the performance of an index and have a professional mutual fund manager. The idea is that with careful investment selection, they will get higher returns than the index.

Different Types of Mutual Funds

There are numerous types of mutual funds that investors can choose to invest in.

Breaking Down Various Mutual Fund Types

Mutual funds can invest in stocks, bonds, real estate, commodities, and more. There are tens of thousands of mutual funds that cover almost every investing strategy you can imagine. Those can include asset class funds, sector funds, or target date funds, among many others.

Asset Class Funds

Asset classes are groups of similar assets that share similar risks, such as stocks, bonds, cash, or real estate. Some funds specialize in a particular type of investment or asset class — for example, large-cap growth stocks or high-yield bonds. These mutual funds assume that you or your adviser will choose the strategic mix of funds that’s right for you.

Sector or Industry Funds

Some funds will attempt to represent all or most of the stocks in a particular sector or industry. What’s the difference between a sector and an industry? Sectors are broader than industries — for example, oil is an industry, but energy is a sector that also includes coal, gas, wind, and solar companies. The stocks in each industry or sector share similar characteristics and risks.

Target Date Funds

A target date fund will provide you with a mix of asset classes (for example, 20% bonds and 80% stocks), and investors choose them with a particular date and goal in mind, usually retirement. These funds shift to less risky investments as the target year approaches.

Target-date funds are intended to be a simple, low-cost solution to retirement saving. They can be a good choice for a 401(k) investment if you don’t have the time or expertise to pick funds.

💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.

The Financial Mechanics of Mutual Funds

As mentioned, mutual funds pool money from a group of investors and invest it for them in various securities. That seems simple enough — but figuring out how to price shares is a bit more involved.

The Pricing Puzzle: Net Asset Value Explained

Mutual funds are companies, and investors purchase shares of the company. Share prices of mutual funds are equivalent to its per share net asset value, or NAV (not including potential fees). NAV corresponds to the net value of all the fund’s assets, with liabilities subtracted. Then, the number is divided by the number of shares outstanding.

In effect, investors can calculate share prices using the NAV formula if they wish.

Fee Structures: Costs Associated with Mutual Fund Investing

There are also costs associated with mutual funds. All mutual funds have some expenses, but they can vary a lot from one fund to another. It’s important to understand them, because fund expenses can have a big impact on your returns over time.

Another consideration with actively managed funds is that they typically cost more because funds are paying people who make investment decisions, and they are making more trades, which have transaction costs. As such, you may want to look out for operating expenses or transaction fees.

You won’t get a bill, but your returns on the fund will be reduced by the fund’s expenses. Some brokerage firms also charge commission for buying mutual funds.

The Pros and Cons of Investing in Mutual Funds

Like all investments, mutual funds have pros and cons that investors should consider.

Potential Benefits of Diversification and Professional Management

The two biggest potential advantages of mutual funds are likely the built-in diversification that they offer investors, and in many cases, professional management. The diversification element may allow some investors to take a “set it and forget it” approach to their portfolio management, and some may find confidence knowing that professional fund managers are steering the ship.

Considering the Risks: No Guarantees and Potential for High Costs

Cons include the fact that there’s no guarantee in terms of returns (there never are when investing!), and the costs associated with mutual funds. As noted, mutual funds may incur additional costs compared to other investment types, depending on the individual fund. That may turn some investors off.

Taxes and Cash Drag: The Other Side of Mutual Funds

Taxes are another potential consideration, as investors will need to pay capital gains taxes on mutual fund payouts throughout the year. And cash drag (or performance drag), which refers to the difference between the return on an investment that has no costs associated with it and an investment that has costs, such as trading costs, can be another thing for investors to think about.

Mutual Fund Investments and You

How can you determine if mutual funds are right for your strategy or portfolio? It may require some consideration of your goals, time horizon, and risk tolerance.

Are Mutual Funds Right for Your Portfolio?

There’s no way to say definitively that a certain investment or investment type, like mutual funds, are “right” for any given investor. But in a general sense, mutual funds may be a choice to consider if you’re a new or young investor, and looking to add some out-of-the-box investments to your portfolio. Again, mutual funds are typically already diversified to a degree, and are often managed by professionals.

Can You Cash Out Anytime? Understanding Liquidity

Mutual funds are not as liquid as stocks or other investments, but they are fairly liquid. That’s to say that if you want to cash out or sell your mutual fund holdings, a prospective trade will only execute once per day — after the stock markets close at 4pm ET. Conversely, stocks can trade any time during market hours.

Mutual Funds Compared to ETFs

Mutual funds are, in many ways, similar to other types of investments, like ETFs.

Mutual Funds vs ETFs: A Comparative Analysis

Mutual funds have been around in the U.S. in 1924, but exchange-traded funds, or ETFs, are relatively new, having debuted in the U.S. in the early 1990s Traditional (old-school) mutual funds are issued by the fund sponsor when you buy them and redeemed when you sell them.

They are priced once a day, after the market closes, at the value of all the underlying securities in the fund, minus liabilities, divided by the number of fund shares — again, their net asset value (NAV).

Exchange Traded Funds (ETFs) trade on stock exchanges throughout the day. You buy them from and sell them to another investor — just like a stock.

Since the assets in the fund are constantly changing value throughout the day, and the fund price is set by market supply and demand, it might trade a little higher or lower than its NAV at different points in the day, but ETFs generally track their NAV closely. Both traditional funds and ETFs can be actively or passively managed.

ETFs have two potential advantages — liquidity and cost. Even though you may pay a commission for buying or selling them, just like a stock, they generally have lower expenses.

Since they can be bought or sold whenever the market is open, you don’t have to wait until the end of the day to buy or sell. This liquidity can be a big advantage on days when the market is way up or way down.

Understanding Fund Classes and What They Mean for Your Investment

There are some mutual funds that offer classes of shares, or different types of shares (similar to some stocks). The different classes of shares tend to correlate to the types of fees or expenses associated with them. Investors may find Class A, Class B, and Class C shares on the market for certain funds, for example.

Class A shares tend to charge fees up front and have lower ongoing expenses, which may be attractive to long-term investors. Class B shares may have high exit fees and expense ratios. Class C shares tend to have mid-level expense ratios and small exit fees, and are often popular with the typical investor.

Getting Started with Mutual Funds

If you think mutual fund investing may be an option for your strategy, getting started can be relatively simple.

Steps to Your First Mutual Fund Investment

The first thing to do if you’re looking to invest in mutual funds is to sit down and do some homework. As discussed, there are myriad mutual funds out there, and they’re all different. You’ll want to pay close attention to what each fund offers, the costs associated with it, and the risks, too.

If you’ve found a mutual fund that you think is a good fit for your portfolio, you could choose a brokerage or online platform that will allow you to buy shares of a given fund, or otherwise have an account that you can trade with, such as a retirement account.

From there, it’s more or less about placing an order and executing the trade. And, after that, it’s about managing and rebalancing your portfolio every so often.

Working With Financial Advisors: Finding Guidance in Mutual Fund Investing

As with all investments, if you feel that you could use some guidance with mutual fund investing, you could reach out to a financial professional. Financial advisors should be able to help you figure out which funds might be suitable, describe their fees and risks, and help guide you in making a selection that could put you on track to reaching your financial goals.

The Takeaway

Mutual funds are companies that pool investors’ money, and then invest it in numerous types of securities on their behalf. Investors can purchase or invest in shares of mutual funds and add them to their portfolios. Mutual funds can be useful to new or beginner investors, as they offer a degree of built-in diversification, and often, active management.

Mutual funds may have higher costs than other investments, though, which is something investors should consider. Further, there are thousands of mutual funds on the market, which may be overwhelming to some. If you’re interested in investing in mutual funds, it may be a good idea to speak with a financial professional for guidance.

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FAQ

How do you make money in mutual funds?

An investor may make money in mutual funds through capital gains and dividends when (and if) the fund grows in value. You could also make money by selling the shares of your mutual funds for more than you originally paid for them. However, making money in mutual funds is not guaranteed, and you could potentially lose your investment, as well.

What is the downside of mutual funds?

A downside of mutual funds is the cost involved — they typically have higher costs than other common types of investments, such as index funds and ETFs. Another downside is the potential risk of poor management. If a mutual fund is actively managed, and the management makes poor decisions, that could affect an investor’s returns.

What are some different types of mutual funds?

Different types of mutual funds include asset class funds, which are funds that specialize in a particular asset class or type of investment; target-date funds that have a mix of asset classes with a particular end date or goal in mind; and sector or industry funds that reflect the stocks in a particular industry or sector.