How Installment Loans Work

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An “installment loan” is a broad, general term that refers to the overwhelming majority of both personal and commercial loans extended to borrowers. Installment loans include any loan that is repaid with regularly scheduled payments or installments.

If you are thinking about applying for an installment loan there are pros and cons to consider first. Here’s what you need to know before taking one out.

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Key Takeaways

  • Installment loans are personal or commercial loans that borrowers must repay with regularly scheduled payments or installments.
  • For each installment payment, the borrower repays a portion of the principal borrowed and also pays interest on the loan.
  • Examples of installment loans include auto loans, mortgage loans, personal loans, and student loans.
  • The advantages of installment loans include flexible terms and lower interest rates.
  • The disadvantages of installment loans include the risk of default and loss of collateral.

What Is an Installment Loan?

An installment loan provides a borrower with a fixed amount of money that must be repaid with regularly scheduled payments. Each payment on an installment debt includes repayment of a portion of the principal amount borrowed and also the payment of interest on the debt.

The main variables that determine the amount of each regularly scheduled loan payment include the amount of the loan, the interest rate charged to the borrower, and the length or term of the loan. The regular payment amount, typically due monthly, stays the same throughout the loan term, making it easy for the borrower to budget in advance to make the required payments.

Borrowers generally have to pay other fees in addition to interest charges, such as application processing fees, loan origination fees, and potential extra charges such as late payment fees.

Types of Installment Loans

Common types of installment loans are auto loans, mortgage loans, personal loans, and student loans. Other than mortgage loans, which are sometimes variable-rate loans where the interest rate changes during the term of the loan, nearly all installment loans are fixed-rate loans, meaning the interest rate charged over the term of the loan is fixed at the time of borrowing.

Secured vs. Unsecured Installment Loans

Installment loans may be either secured (collateralized) or unsecured (non-collateralized). Mortgage loans are collateralized with the house the loan is being used to purchase, and the collateral for an auto loan is the vehicle being purchased with the loan.

Some installment loans (often referred to as personal loans) are extended without collateral being required. Loans extended without the requirement of collateral are made based on the borrower’s creditworthiness, usually demonstrated through a credit score, and the ability to repay as shown by the borrower’s income and assets.

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The interest rate charged on a non-secured loan is usually higher than the rate that would be charged on a comparable secured loan, reflecting the higher risk of non-repayment that the creditor accepts.

If you’re considering taking out an installment loan, you may want to first check out a personal loan calculator to determine what kind interest rate you’ll be able to afford.

Applying for an Installment Loan

A borrower applies for an installment loan by filling out an application with a lender, usually specifying the purpose of the loan, such as the purchase of a car. The lender discusses with the borrower various options regarding issues such as down payment, the term of the loan, the payment schedule, and the payment amounts.

If an individual wants to borrow $10,000 to finance the purchase of a car, for example, the lender informs the borrower that making a higher down payment could get the borrower a lower interest rate, or that the borrower could obtain lower monthly payments by taking out a loan for a longer term. The lender also reviews the borrower’s creditworthiness to determine what amount of credit and what loan terms the lender is willing to offer.

The borrower ordinarily retires the loan by making the required payments. Borrowers can usually save interest charges by paying off the loan before the end of the term set in the loan agreement.

Some loans impose prepayment penalties if a borrower pays off their loan early.

Advantages and Disadvantages

Installment loans are flexible and can easily be tailored to the borrower’s specific needs in terms of the loan amount and the length of time that best matches the borrower’s ability to repay it. These loans let the borrower obtain financing at a substantially lower interest rate than what is usually available with revolving credit financing, such as credit cards. This way, the borrower can keep more cash on hand to use for other purposes, rather than making a large cash outlay.

Pros

  • Ability to finance big purchases

  • Payment amount typically stays the same throughout loan term

  • Usually possible to save interest charges by paying off loan early

Cons

  • Loan fees can be high

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  • Credit can be damaged due to late or missed payments

  • Potential to borrow more than needed

For longer-term loans, a disadvantage is that the borrower might be making payments on a fixed-interest loan at a higher interest rate than the prevailing market rate. The borrower may be able to refinance the loan at the prevailing lower interest rate.

The other main disadvantage of an installment loan stems from the borrower being locked into a long-term financial obligation. At some point, circumstances may render the borrower incapable of meeting the scheduled payments, risking default, and possible forfeiture of any collateral used to secure the loan.

Installment Loans and Credit Scores

Paying off an installment loan on time is an excellent way to build your credit. Payment history is the most important factor that contributes to your credit score and a long track record of responsible credit use is good for your credit rating.

As mentioned earlier, your credit score can take a hit if you don’t make timely payments or you default on the loan—which is also a red flag in the eyes of lenders.

The Bottom Line

An installment loan can help you finance a major purchase, such as a car or home. Like any loan, there are pros and cons to consider. Advantages include flexible terms and lower interest rates, while a major disadvantage is the risk of default.

If you decide to take out an installment loan, be sure to shop around and compare rates and terms offered by lenders before signing on the dotted line. [external_footer]