What Is an Installment Loan?
Many people wonder, “What is an installment loan?” If you’re one of those people, that’s OK! Unless you work day in and day out as a realtor, banker or mortgage broker, specific loan and banking terms may be a bit confusing.
The good news, though, is with the right explanation, you can understand what an installment loan is, the different types available, how they work, and what it all means for you as a consumer. Installment loans are a great way for consumers to get access to money to make major life purchases.
Installment loan definition
Installment loans are a form of borrowing where the borrower receives a lump sum of money and pays back the lump sum plus interest in structured and regularly scheduled payments over an agreed upon period. The amount borrowed is known as the principal, and the premium to borrow the money is known as the interest. The interest is expressed as a percentage of the principal. Auto loans, student loans, mortgages and personal loans are all types of installment loans — but as with all types of credit products, each loan type offers different terms and ways to qualify.
For example, let’s say that you borrow $10,000 to buy a car with a $1,000 flat fee (representing interest to simplify the explanation) as the cost of borrowing. You agree to pay back the loan with monthly payments for the next 60 months. You will owe $11,000 total for 60 months, or $11,000/60 months = $183.33 per month. Every month for the next 60 months, you will pay the lender $183.33. In return for this, the lender will give you $10,000 upfront to make your car purchase.
You get your car right away without having to wait, and the lender makes a small profit over the long run in return for lending you the money.
Types of installment loans
Installment loans come in all shapes and sizes and can be used to meet several different borrowing needs. The three most common types of installment loans are auto loans, home loans and personal loans.
Installment loans for car purchases are available for new or used cars. Typically, you can acquire an auto installment loan through a traditional lender, bank, credit union or through the car dealership itself. Installment repayment periods on auto loans range from 12 months out to 72 months and come with a wide range of terms and interest rates.
Home mortgages are one of the most common types of installment loans available on the lending market, and they are often the largest loans by dollar amount. Commonly known as mortgages, these installment loans allow borrowers to get funding to purchase houses, condos or other types of property. As the loans are much larger, repayment periods can be anywhere from 10 years to 30 years and interest rates will vary based on credit scores, financial health and other factors decided on by the lender.
For those borrowers who need access to funds for something other than a car or a home, a personal loan may be the best fit. These installment loans come in all shapes and sizes, with a wide array of rates and payback terms. The two main categories of personal installment loans are secured and unsecured. Secured personal loans are backed by collateral, which means you agree to give the lender something if you default on the loan. This makes things less risky for the lender, so secured personal loans usually carry a lower interest rate and APR.
The bulk of personal loans, though, are unsecured, which means you aren’t required to put up any collateral for approval. Your approval is generally based on the amount you want to borrow, what it’s for, and your past credit and borrowing history. Because these types of personal loans are riskier to lenders, you can expect to pay a higher interest rate and APR on the loan. Rates on all installment loans are typically set based on the amount of risk or perceived risk the lender is accepting.
Advantages of installment loans
More time to pay the loan back
With most installment loans, the repayment periods are 12 months or greater. With auto loans and personal loans, you’re looking at several years. With home loans, you’re looking at several decades. Because of this, it allows you to spread out major purchases over a longer period, which could make something you can’t afford to pay up front more affordable.
Streamlined payback terms
With installment loans, you’re going to know what you owe every month before you sign the loan. This certainty in payment size and frequency can make budgeting and future financial planning much easier and more effective.
Access to larger sums of money
Unlike payday loans or other forms of fast cash, installment loans give you access to large sums of money. If you need several hundred thousand dollars for a house, you can get it through an installment loan. Trying to buy a house or a car through a payday loan is just not going to happen.
Great credit builders
Installment loans can be a great source of building a credit history. Your credit score is a representation of your reliability when it comes to paying back borrowed money. By taking out an installment loan and making good on the payments, you demonstrate to the credit reporting bureaus that you’re a reliable borrower. What does this mean for you? It means a better credit score, which means access to more money, better rates and more favorable borrowing terms in the future.
Drawbacks of installment loans
Unlike shorter-term forms of financing, installment loans will follow you for a longer period. Yes, this means lower payments and access to more money, but it also means regular payments for most likely several years. Even if you don’t like what you purchased down the road, you’re still going to be responsible for the money owed on your installment loan.
Installment loans are a great way for borrowers to get access to cash for major purchases or other substantial costs. By being able to spread out your payments over a few months, years or decades, you can break up the cost of more expensive items. You will pay a premium (interest) for the access to the funds, but there’s a good chance you’ll be OK with the tradeoff.