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The term “installment loan” may not sound familiar, but you probably know about — or have even used — many types of common installment loans.
So what exactly is an installment loan? It’s a type of loan that allows you to borrow a set amount of money when you take out a loan. Unlike forms of revolving credit, such as credit cards or a line of credit, you must decide exactly how much money you need before borrowing the funds.
After borrowing the funds, you then have to repay the installment loan over a fixed period of time, which you and the lender determine when you take out the loan. Payments are typically monthly, but schedules can vary.
Each payment is known as an installment, which is why it’s called an installment loan.
Common examples of installment loans
Many of the most common types of loans people take out are considered installment loans. Auto loans, mortgages, personal loans and student loans are all types of installment loans.
Auto loans are typically repaid in monthly installments over a range of 12 to 96 months, although not all lenders issue loans with terms within that range. Loans with longer terms often come with lower monthly payments, and higher interest rates, too. This means you’ll end up paying more overall to buy a car with an 84-month loan, even if your monthly payments are lower, than with a 36-month loan.
A mortgage is an installment loan used to borrow money to buy a house. Mortgages are typically repaid over 15-to-30-year terms with monthly payments.
Some mortgages come with fixed interest rates that typically don’t change. This means the standard monthly principal and interest payments won’t change, either.
Personal loans are a type of installment loan you can use for a variety of purposes, like consolidating debt or paying off sudden expenses like medical bills. Personal loans typically have terms between 12 and 96 months. They usually have higher interest rates than other kinds of loans. This may be because personal loans don’t require collateral, like your car or house.Read more: What is collateral?
Benefits of installment loans
In most cases, installment loans will come with predictable payments. If you take out a fixed-interest-rate loan, the core components of your payment (outside of changes to loan add-ons, like insurance) will likely remain the same every month until you pay off your loan.
A predictable payment amount and schedule could make it easier to budget for your loan payment each month, helping you avoid missing any payments because of unexpected changes to the amount you owe.
When shopping for an installment loan, make sure the monthly payments won’t stretch your budget. If they do, you might have trouble making your full payment when a financial emergency pops up.
Installment loans also offer the comfort of knowing your debt can be paid off by a specified date. After you’re done paying the number of installments required by the loan, your debt should be paid off in full. If you get a loan with the shortest payment term you can reasonably afford, you can get out of debt faster and will probably pay less interest.
Drawbacks of installment loans
Unfortunately, installment loans can have their downsides.
For instance, once you take out the loan, you can’t add to the amount you need to borrow, like you can with a credit card or line of credit. Instead, you’ll have to take out a new loan to borrow more money. When shopping for an installment loan, make sure you know exactly how much you need to borrow.
Another potential drawback of installment loans is that your interest rate and other loan terms are largely based on your credit. If you’ve struggled with credit in the past and have less-than-stellar credit scores, chances are you’ll have to pay a higher interest rate than borrowers with strong credit histories.
Higher interest rates result in larger monthly payments and a higher total cost of borrowing. If possible, work to improve your credit health before applying for an installment loan.
Besides interest, installment loans can come with other fees and penalties. Some lenders require you to pay application fees (often called origination fees) and credit check fees, which increase your total cost up-front. They also sometimes charge prepayment penalties, which require you to pay a fee when paying the loan off early.
If you’re considering an installment loan, make sure you understand the terms and conditions of the loan you’re agreeing to. If you understand what’s being offered, you can thoughtfully shop around for the best installment loan for your particular situation.