With an installment loan, you receive a lump sum of money up front and then pay it back (plus interest) in a series of fixed payments over the term of the loan. The repayment period can be several months to many years.
There are many types of installment loans, including personal loans, mortgages, and auto loans. Read on to learn exactly how these loans work, their pros and cons, and how they compare to revolving loans.
What Is an Installment Loan?
Simply defined, an installment loan is a type of loan that allows you to receive the full borrowing amount (loan principal) all at once and then repay it in fixed monthly installments over a set period (the loan’s term). Each installment consists of both principal and interest, and the loan term can range from a few months to several years.
Common examples of installment loans include car loans, mortgages, personal loans, and student loans.
Installment loans are also known as closed-ended loans (or closed-ended credit accounts). They differ from revolving loans, like credit cards, which are open-ended accounts. With an open-ended account, you can use and repay funds repeatedly for as long as the account remains open and in good standing.
How Do Installment Loans Work?
When you take out an installment loan, you immediately receive the principal. You then start paying it off — typically with interest — in regularly scheduled payments for a set number of weeks, months, or years. Once the loan is paid back in full, the account is closed.
To better understand how installment loans work, let’s consider an example:
Let’s say you need to borrow $10,000 to cover home repairs. You apply for a personal installment loan with a 5% annual percentage rate (APR) and a loan term of 3 years. If approved, you’ll receive the full $10,000 upfront. Over the next 36 months, you’ll make fixed monthly payments, including principal and interest, until the loan is fully repaid.
Pros and Cons of Installment Loans
To better understand if a personal installment loan is the right fit, let’s look at some pros and cons associated with this type of lending product.
| Pros | Cons |
|---|---|
| Provides funds for a large purchase | Interest and fees add to your costs |
| Fixed payments help with budgeting | May have long repayment period |
| May have lower interest rates than other loan products | May need good credit to qualify |
Pros
• Helps you cover a large expense Installment loans can give you quick access to the money you need for bigger purchases, such as a house, car, or home renovation.
• Predictable payments Interest rates are typically fixed and each loan payment is the same throughout the loan term, making budgeting easier.
• Structured repayment Installment loans have fixed repayment schedules, ensuring you know exactly when the loan will be paid off.
• Access to larger amounts Installment loans often allow for borrowing larger sums compared to other types of loans.
• Potential lower interest rates Depending on your creditworthiness, installment loans may offer lower interest rates than credit cards or payday loans.
Cons
• Interest costs Typically, borrowers need to pay interest on the loan amount, which adds to the total cost.
• Credit requirements Qualifying for installment loans may require a good credit score, making them less accessible for individuals with poor credit.
• Potential fees Some lenders may charge origination fees or prepayment penalties, so it’s essential to review the terms and conditions.
• Not open-ended It’s unlikely you’ll be able to add to your loan amount if you find you need more.
• Potentially long commitment Some installment loans come with long repayment terms, which means you must commit to making regular payments over a long period of time.
Installment Loans vs Revolving Credit
Installment loans work differently than revolving credit. With revolving credit, you don’t receive a lump sum of money up front and then pay it back (plus interest) on a set schedule. Instead, you get approved for a certain credit limit, then borrow what you need (up to your approved limit) as you need it. You only pay interest on what you borrow and, once you repay what you’ve borrowed, that money becomes available to borrow again.
Here’s a closer look at how installment loans compare to revolving credit.
| Installment Loans | Revolving Credit | |
|---|---|---|
| Payment structure | Fixed monthly payments | Minimum payment due varies monthly |
| Loan term | Predetermined | No fixed term |
| Interest charges | Interest applied to entire balance | Interest applied to outstanding balance |
| Credit limit | Borrow a lump sum up front | Pre-approved credit limit/td> |
| Interest rates | Tend to be lower | Tend to be higher |
Types of Installment Loans
Installment loans are available for various purposes. Here are some common types.
Auto Loans
Car loans are a common type of installment loan. Typically, you make a down payment on a car, then take out an auto loan to cover the purchase price balance. You then make monthly fixed payments to the lender for the term of the loan, which can range anywhere from 24 to 84 months.
Mortgages
Mortgages are long-term installment loans used to finance the purchase of a home. You typically make a downpayment (say 20% of the home’s purchase price) and get a loan for the balance at an agreed-upon interest rate. Common mortgage loan terms are 15 or 30 years.
Personal Loans
Personal loans are typically unsecured installment loans that can be used for various purposes, such as debt consolidation, paying for a wedding, or making home improvements. You receive the funds in a lump sum and once you get the cash, you must make payments until the debt has been fully repaid. Terms can be anywhere from one to seven years.
Student Loans
Student loans are a type of installment loan that pay for college and related expenses (including tuition, fees, books, and living expenses). There are two types of student loans — federal and private student loans. Which type you get will determine how your interest rate is calculated and your repayment options.
Buy Now, Pay Later Loans
Buy now, pay later loans allow you to make purchases and pay them off over time, typically interest-free if repaid within a specific period, which is generally a few weeks. If you don’t repay the loan within the set term, however, you can end up paying high interest rates and fees.
Installment Loans and Credit Scores
The typical credit requirements to qualify for an installment loan vary among lenders. Generally, a higher credit score increases your chances of approval and may lead to more favorable loan terms, such as lower interest rates. Lenders may also consider factors like income, employment history, and debt-to-income ratio when evaluating your application.
The Takeaway
Installment loans can provide a helpful financing solution for various needs, offering predictable repayment schedules and the ability to borrow larger sums. However, it’s essential to carefully consider the pros and cons, compare different types of loans, and review credit requirements before applying.
Taking the time to understand installment loans will help you make informed decisions and choose the best financing option for your specific circumstances.
If you are thinking about using a personal installment loan to cover a large expense, you may want to consider a SoFi personal loan. SoFi personal loans offer competitive, fixed rates and a variety of terms. Checking your rate won’t affect your credit score, and it takes just one minute.
FAQ
Is there a difference between personal loans and installment loans?
Yes. Personal loans are a specific type of installment loan, but not all installment loans are personal loans. Installment loans, in general, refer to loans that are repaid in fixed monthly installments over a specific period. Personal loans, on the other hand, are installment loans that can be used for various purposes, such as debt consolidation or unexpected expenses.
Which consumer loans are installment loans?
Several types of consumer loans are considered installment loans. Some common examples include:
• Auto loans
• Mortgages
• Personal loans
• Student loans
• Buy now pay later loans
These loans are repaid in regular installments over a predetermined period.
Can installment loans hurt your credit score?
Installment loans can potentially impact your credit score. If you make timely payments and manage the loan responsibly, it can have a positive effect on your credit by demonstrating your ability to handle debt. If, on the other hand, you miss payments or default on the loan, it could negatively impact your credit. It’s important to pay each installment in full and on time to maintain a good credit score.
Photo credit: iStock/Delmaine Donson
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