Learn what it’s like to use one of these loans, the pros and cons of installment debt, and which alternatives might be a better fit for your needs.
What Are Installment Loans?
Installment loans are loans that you repay with a series of monthly payments. They typically have a fixed interest rate, and each monthly payment is the same. Fixed-rate home and auto loans are the most common types of installment loans, but personal loans, student loans, and other types of loans are also forms of installment debt.
Alternate name: Closed-end credit
How Does an Installment Loan Work?
Installment loans allow you to make large purchases or consolidate debt using borrowed money instead of your own. With a repayment term that lasts several years (or several decades), the payments are relatively small, making things like homes and automobiles affordable. An installment loan is generally a one-time loan that provides money in a lump sum. Lenders calculate your monthly payment so that each payment reduces your loan balance and covers your interest costs, eventually bringing your balance to zero over the term of your loan. In most cases, the lender will let you see what your monthly payment will be before you accept the loan they offer. Personal loan lenders often provide preliminary monthly payment quotes without affecting your credit.
Installment Loan Example
Suppose you borrow $20,000 to purchase a car using a four-year auto loan. With a 4% interest rate, you have 48 equal payments of $451.58. Each payment, known as an “installment,” pays interest charges and helps to reduce your loan balance or “principal,” but your first payment only pays off $384.91 of your loan balance. The remaining $66.67 of your payment is your interest cost. Over time, you pay off your loan balance in bigger chunks, and your interest costs decline. After your 48th payment, your loan balance will be zero. To learn more about how this works, get familiar with loan amortization and how to build your own amortization tables.
Secured vs. Unsecured Loans
Some loans require you to use collateral when you borrow. For example, an auto loan is secured by the vehicle you purchase. If you stop making payments, lenders can repossess the vehicle. Home loans are similar, allowing lenders to foreclose on your home. Unsecured loans do not require collateral. Many personal loans are unsecured loans, which means there is no asset for your lender to take if you stop making payments. Instead, lenders may report late payments to credit bureaus and take legal action against you.
Types of Installment Loans
Personal loans: Unsecured personal loans are often available as installment loans. Banks, credit unions, and online lenders offer these loans for almost any purpose. Auto loans: When you purchase a vehicle, you typically have a fixed monthly payment for the life of your loan. Home purchase loans: Traditional 30-year fixed-rate and 15-year mortgages are standard installment loans. Home equity loans: When you get a second mortgage, you can receive funds in a lump sum and pay off the debt in installments. Student loans: Student loans are generally installment loans. Each time you borrow, you typically get a new loan. Other types of loans: There are many types of installment loans. They might have specific names, such as RV loans, fertility loans, dental loans, or landscaping loans, but they’re all typically forms of installment debt.
Pros and Cons of Installment Loans
Monthly Payments Are Fixed in Most Cases
Installment loans usually have a flat monthly payment amount that does not change. As a result, it’s easy to budget for those payments over the coming years.
Cost of Large Expenses Spread Out Over Time
These loans make it possible to make expensive purchases, like a home or a car. Unless you have enough money set aside to pay cash, an installment loan might be your only option for buying.
Debt-Payoff Date Is Known in Advance
Unlike credit cards, installment loans have a payoff schedule with a specific number of months. You gradually reduce debt with each payment, and your loan balance will be zero at the end of your loan term.
One-Time Loan Does Not Allow Additional Borrowing
Installment loans are generally one-time loans that provide money in a lump sum. If you need additional funds after you borrow with an installment loan, you may need to apply for a new loan or find other funding sources. Credit cards and other lines of credit allow you to borrow repeatedly.
Borrowing Fees Can Be High
Installment loans may charge fees that add to your cost of borrowing—sometimes substantially. Home loans may have closing costs that amount to thousands of dollars. Personal loans may charge origination fees of 1% to 8% of your loan amount, and that fee comes out of your loan proceeds. Some payday loan shops offer installment loans that can end up costing up to 400% APR.
Limitations of Installment Loans
While loans make it possible to buy a home or pay education expenses, there are drawbacks to borrowing. An installment loan is a monthly obligation. If you’re unable to keep up with the payments, you risk damaging your credit or losing collateral attached to the loan. Life is uncertain, and you might not know exactly how much money you need and when you’ll need it. When you borrow with a one-time loan, you may not be able to qualify for additional loans if you max out your debt-to-income ratios. A credit card or other type of credit line might provide more flexibility.
Alternatives to Installment Loans
If you need to borrow money and don’t want an installment loan, the primary alternative is a line of credit. Those loans, also known as “revolving loans,” generally allow you to borrow multiple times until you reach your maximum credit limit. For example, you might borrow with a credit card or a home equity line of credit (HELOC).
