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, you may be wondering what an installment loan is and how it works. We’ll provide some insight that may help.
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.
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What Is an Example of an Installment Loan?
Installment loans can have multiple uses. These include auto loans, personal loans, mortgages, and student 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, 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 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.
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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.
Some student loans have a grace period, a period after graduation during which you aren’t required to make payments, and, 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||Cons of Installment Loans|
|Can cover small or large expenses||Interest charges on entire loan amount|
|Predictable payments||Can’t add to loan amount once it’s been finalized|
|Can refinance to lower rate||Can come with long repayment terms|
Pros of Installment Loans
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.
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.
You may be able to refinance your loan to a lower rate if you’ve improved 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.
Recommended: Can You Refinance a Personal Loan?
Cons of an Installment Loan
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.
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.
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 deep 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 less-than-stellar 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.
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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.
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.
• Pre-qualifying 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
If you’re looking for a loan, an installment loan might fit your needs. Shopping around for an installment loan is a good way to find the best rates and terms for your unique financial situation and needs.
SoFi Personal Loans are installment loans with competitive, fixed rates and terms that can fit a variety of budgets. SoFi never charges a fee on its personal loans, so you’ll only have to repay the principal and interest.
What is an installment loan and how does it work?
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.
Photo credit: iStock/Ridofranz
*Checking Your Rates: To check the rates and terms you may qualify for, SoFi conducts a soft credit pull that will not affect your credit score. However, if you choose a product and continue your application, we will request your full credit report from one or more consumer reporting agencies, which is considered a hard credit pull and may affect your credit.
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