What Is an Installment Loan?
6 Min Read
Are you wondering how installment loans work? They’re a common loan product, and you may have used one without even noticing.
Installment loans are upfront cash payments from banks, credit unions, or private lenders that a borrower pays back in fixed installments according to the agreed-upon loan terms. Before you apply for an installment loan, here are the ins and outs of how this product works.
How Do Installment Loans Work?
Unlike revolving credit, an installment loan is a closed-ended loan, which means you receive all the money you want to borrow in one payment from your lender. You repay the loan over months or years in equal monthly payments called installments. These loans can be hundreds to thousands of dollars and can be secured with collateral, like mortgage, unsecured, or signature loans.
The interest rate on installment loans come with fixed interest rates or variable, depending on the type of loan. You’ll make payments toward the principal balance and interest until it’s repaid. The interest rates on installment loans change over time, and they can depend on the type of loan you take out and your credit history and credit report.
Installment loans are often confused with payday loans. These are short-term, no-credit-check loan products that require full repayment taken directly from your next paycheck. Payday loans aren’t cheap, and many people use these in emergency situations.
5 Types of Installment Loans
There are many different types of installment loans, and personal loans are the most common. While some have a specific purpose, others can be used to purchase almost anything. Here are five types of loans.
Personal loans are one of the most flexible types of installment loans, but they come at a high cost. Personal loans can be used to consolidate debt or finance expensive home or car repairs.
Most personal loans are unsecured, and the lender decides your interest rate and how much you qualify for based on your credit profile and debt-to-income (DTI) ratio.
A mortgage is an installment loan used to purchase a home and is typically paid back over the next 15 to 30 years, depending on the loan terms. The home secures the loan, and you risk foreclosure if you’re unable to pay the outstanding balance within three to six months of the first missed payment. Mortgage interest rates tend to be lower than other loans, but qualifying for a mortgage is more complicated.
When you purchase a new or used car with an auto loan, you must make monthly payments, including interest, over the next two to five years until the loan is paid in full. The auto loan is secured by the car, and missed payments can result in the repossession of the vehicle.
Student loans (federal and private) are unsecured loans that help college students cover the cost of tuition, housing, textbooks, classroom supplies, transportation, and more. Borrowers usually aren’t required to make payments while attending school, but interest will build as soon as loan funds are disbursed.
Buy Now, Pay Later (BNPL) Loan
A buy now, pay later loan is a form of short-term financing offered during checkout from online retailers. BNPL loans are interest-free and are typically broken up into equal payments spread out over several weeks. For example, if you make a $400 purchase and choose to finance with a BNPL loan, you’ll repay the loan in four installments, or $100 every two weeks.
Pros and Cons of Installment Loans
Installment loans allow borrowers to finance what they need, but it comes at a cost. Below are advantages and disadvantages of taking out an installment loan.
- Set monthly payments: Many types of installment loans offer fixed monthly payments. This means predictable payments with no surprises.
- You can potentially raise your credit score: Payment history makes up the biggest chunk of your FICO credit score — approximately 35%. When you make on-time payments, lenders see you as less of a risk.
- Finance large purchases: Most people can’t buy a car or a house in cash. Installment loans make it possible to make these big purchases.
- Refinancing is possible: If interest rates drop or if you improve your credit score, you can refinance your loan for a lower monthly payment or to shorten the length of your loan.
- You could pay much more than you borrowed: A lower credit score is a signal to lenders that you may be a high-risk borrower. To help offset this risk, lenders will offer a higher interest rate. Additionally, if you decide to pay the installment loan early, the lender could charge a prepayment penalty.
- You can’t add to your loan amount: An installment loan is a closed-ended loan. This means you can’t take out more money after you’re approved and receive your payment.
- You’re on the hook for a long period of time: Some installment loans have longer repayment periods, like a 30-year mortgage. This means you’re responsible for the loan during this entire period.
Can I Get an Installment Loan With Bad Credit?
FICO credit scores range between 300 and 850. According to Experian, a good credit score is around 700, while a score between 300 and 579 needs some work.
It’s not impossible to qualify for an installment loan with a bad credit score, but it often means you’ll have a higher interest rate.
If necessary, consider adding a co-signer with a better credit score. A co-signer takes responsibility for the loan if you don’t make your loan payments on time. This can help you qualify with a bad credit score and make the loan more affordable.
What Happens if I Miss a Payment?
After 30 days, most lenders report the missed payments to the three major credit bureaus — Equifax, Experian, and TransUnion. But some lenders may not report it until 60 days after the due date. If you have a secured loan, like an auto loan, the lender could repossess your vehicle to pay back the loan.
Contact your lender if you’re having trouble making payments. You may qualify for deferment or forbearance, or your lender could offer to put you on a payment plan. This would allow you to postpone payments, make partial payments, or receive a lower interest rate.
Is an Installment Loan a Good Idea?
Whether an installment loan is a good idea depends on your financial situation. Installment loans can help make homeownership possible or allow you to get a college education. However, it means you’re paying more than if you paid upfront in cash.
Many loans come with high-interest rates and fees, especially if you have poor credit. Plus, late loan payments can significantly damage your credit score. And if you fall too far behind, you could end up losing your home if you took out a mortgage.
Before taking out an installment loan, make sure you can afford to pay back the loan. With a mortgage, one rule of thumb is that 28% of your monthly income before taxes should cover each payment. If you can no longer afford the loan, reach out to your lender.
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