What Is An Installment Loan?
An installment loan is a way to borrow money for a large purchase, usually a car, home, or college education. After being approved by the lender, the borrower receives a lump sum and repays the loan over a fixed period in monthly payments or installments.
Installment loans work differently than revolving credit, such as credit cards, which provide a line of credit for continuous borrowing rather than making one single payment. Revolving credit allows the money to be re-borrowed once it is repaid, while an installment loan account closes once it is repaid.
If you’re considering an installment loan, here’s what you need to know about what they are and how they work.
Types of Installment Loans
Installment loans fall into two main categories: secured and unsecured.
A secured loan requires collateral—someone’s assets or property—as security against the loan. Lenders can take ownership of the loan’s collateral if you fail to make payments; That means if you can’t pay your auto loan, for example, the lender can repossess your car. A personal loan is a type of installment loan that is usually unsecured, which means that a personal loan usually does not require any collateral.
Here are the most common types of installment loans you’ll encounter:
Personal Loans: These installment loans can be used for various purposes, such as debt consolidation, medical expenses, home renovation or marriage. You can find them at traditional financial institutions like banks and credit unions, and online-only lenders that specialize in quick transactions. Personal loans come in a wide range, and interest rates can vary greatly depending on your credit.
Auto Loan: This installment loan is used while buying a vehicle. Since they are secured with the car as collateral, your car ownership is at risk if you default on your payments. But as a result, auto loans usually have a much lower interest rate than unsecured loans. For example, in the fourth quarter of 2019, the average interest rate on a 48-month new car loan was 5.45%, according to the Federal Reserve. On a 24-month personal loan, the average interest rate was 10.21%.
Mortgage: A mortgage is a secured installment loan used to finance the purchase of a home. As with auto loans, your home is used as collateral to secure the lender, which keeps mortgage interest rates lower than unsecured loan rates. But it also means that your home can be taken from you if you can’t meet your loan obligations.
Student Loans: These are installment loans that pay for higher education and can be issued by the federal government or a private lender. Interest rates, terms, repayment options and forgiveness programs vary depending on whether it is a federal or private student loan.
Payday Loans: Payday loans are a type of installment loan advertised as a way to help borrowers get by until they receive their next paycheck. But with sky-high interest rates and fees, they are known to trap consumers in a cycle of debt and many consider it a form of predatory lending. Consider alternatives instead.
Advantages and disadvantages of installment loans
Installment loans are not inherently good or bad. Whether it is helpful or harmful for you depends on your credit, current financial situation and borrowing needs.
As a borrowing option, installment loans have several potential benefits:
Predictable monthly payments: If you’re on a tight budget, knowing you’ll pay the same amount each month can help you plan expenses. Because installment loans are made using a fixed term such as two years or five years, you also know when you will be able to make the payments.
Fixed interest rate: Many installment loans have fixed interest rates. It adds another level of predictability, because you’ll likely know your rate won’t go up like a variable rate. Some installment loans, such as private student loans, allow you to choose between a fixed and variable interest rate. A variable rate is usually only worth choosing if you plan to pay off your loan quickly and avoid potential rate hikes in the future.
Higher credit limit than plastic: You can usually borrow more money with an installment loan than with a credit card. In many circumstances, if you need to make a large purchase, a loan may be a better option. But home equity lines of credit, which are a type of revolving credit — not an installment loan — can come with higher borrowing limits than credit cards. Typically, you can borrow up to 85% of the value of your home, less what you owe on the mortgage.
Installment loans can also have the following aspects:
Lack of flexibility: If you need to borrow a fixed amount—say, to buy a car—an installment loan is ideal. But if you may need additional funds later, or if you’re not sure how much money you’ll need, you may be better off using revolving credit because of its flexibility. Fixed interest rates can also be a disadvantage; While they mean consistent monthly payments that can make budgeting easier, your rate won’t drop if market conditions change.
Potentially higher rates for some borrowers: Depending on your credit and the type of installment loan you’re considering, average rates may be higher than rates on revolving lines of credit. For example, people with excellent credit can qualify for a personal loan with interest rates as low as 4.99%, but if you have fair or poor credit, the rates you can qualify for can be as steep as 36%. The higher the
In contrast, the average credit card interest rate on all accounts was 14.87% in the fourth quarter of 2019, according to the Federal Reserve. However, those with poor credit will qualify for higher rates.
Installment Loan Vs. Revolving credit
Installment loans and revolving credit are two ways to borrow, but they work very differently. You can think of an installment loan as a one-time transaction that allows you to borrow a set amount, while revolving credit—including home equity lines of credit (HELOC) and credit cards—is more fluid.
When you’re approved for a credit card, for example, you’re given a credit limit that allows you to continue borrowing while you pay your bills. If you carry a balance, you will pay interest on that amount, and only that amount, and you will pay the issuer a minimum monthly payment.
Say you get a new credit card with a $5,000 credit limit. If you have a $1,000 balance, you only pay interest on that $1,000—not $5,000. And once you pay off that $1,000, you can borrow up to $5,000 again.
These offer less predictability than installment loans, but more flexibility. Interest rates on credit cards are generally higher than on many types of loans, especially if you qualify for the lowest installment loan rates. If you never make the minimum payment on a revolving credit account, you could be stuck in debt. This makes revolving credit great as a way to pay for emergency situations, or occasional large purchases, such as furniture or televisions, that aren’t big enough to warrant taking out a loan.
How Installment Loans Affect Your Credit
As is true with any type of borrowing, taking out an installment loan can have a positive or negative impact on your credit. Here’s how:
Payment history: Your payment history is the largest factor in your credit score, making up 35% of the FICO credit scoring model. If you pay all the loan installments on time, it will help strengthen your credit. On the other hand, if you make late payments or fall behind and miss them, your credit will suffer.
Credit mix: Having a mix of different forms of credit can also benefit your credit score. If you don’t currently have a loan, adding one to your credit report can give you a boost, but only after you’re approved. It is not wise to take a loan just for this purpose which you have to fit into your budget. It’s also because applying for a new line of credit will lead to a harder check on your credit report, causing a temporary drop in your score.
Credit Utilization: Your credit utilization ratio is an important factor in your credit score, contributing about 30% to it, according to FICO. This figure shows how much of your total available credit you are using at any given time. Using too much of it can hurt your score and make lenders worry that you’re overburdened with debt. If your credit utilization rate is already high due to large credit card balances or other loans, adding a loan to your credit file can lower your score.
How to know if an installment loan is right for you
Taking an installment loan will affect your budget and have a long-term impact on your credit.
When you receive a loan offer, carefully evaluate whether you have room in your budget for the new monthly payment. Consider: Can you still make your payments if you have a financial emergency? Do you have a savings buffer to help with those situations?
If you are unsure whether you will be able to comfortably repay the loan within the repayment period, talk to your lender about options for updating the offer. Maybe you need a longer term so your monthly payment is lower, or a smaller loan.
Another option is to consider loan options such as credit cards for specific purchases. While credit card interest rates can be higher than personal loan rates, for example, many have introductory offers of 0% APR for 12 months to 18 months, giving you the ability to pay off your balance without paying interest.
Before using a 0% APR credit card, however, make sure you note the regular APR and that you can afford the payments if you still carry a balance. Use an installment loan or credit card responsibly and you have a chance to not only meet your financial goals, but also keep your credit strong.