by Robin Hartill, CFP®
Senior Editor
An installment loan is a lump sum of money that you borrow and then pay back in fixed intervals. Installment loans are often used to finance a major purchase, like a house, car or boat, or to finance education, though you can get an installment loan for practically any reason.
If you’re wondering what an installment loan is, you’ve come to the right place. Learn more about how installment loans work, the pros and cons, and how to get an installment loan.
An installment loan is a type of loan that lets you borrow money and repay it in equal monthly payments or according to another predetermined schedule. You pay back the principal loan amount, plus interest, in fixed monthly payments until you’ve paid back the loan.
Installment loans usually have a fixed interest rate that doesn’t change throughout the life of the loan. However, some installment loans, like private student loans, have a variable interest rate that can change while you pay back the loan.
Some installment loans also charge origination fees to process your application. Depending on the type of installment loan, you may owe prepayment fees if you pay off the loan early. But if you don’t make payments according to the repayment terms or you make late payments, you could incur additional fees and hurt your credit score.
Installment loans work differently than revolving credit, like a credit card. Revolving credit, like a credit card or a line of credit, allows you to borrow money and repay it over and over again, while you make payments on an installment loan until it’s paid off in full. Payday loans are also different from installment loans in that you repay a payday loan in a lump sum instead of fixed installments.
Installment loans can be secured loans, which means they’re backed by collateral, or unsecured loans, which aren’t backed by collateral. Mortgages and vehicle loans are two types of installment loans that are secured. Examples of unsecured installment loans include student loans, personal loans and debt consolidation loans.
A mortgage loan is one of the most common types of installment loans that’s used to purchase a house, condo or land. Your home is the collateral on a mortgage, so if you fail to make payments, your lender can seize your property. Most mortgages are repaid at fixed interest rates over 15 years or 30 years. Your home is the collateral on a mortgage, so if you fail to make payments, your lender can seize your property.
Car loans are also installment loans that are secured loans. Because your vehicle serves as the loan collateral, it can be repossessed if you don’t make car loan payments. Repayment terms typically range from 24 months to 84 months, with the most common being 72 months.
A student loan is an installment loan, whether you’re borrowing from the federal government or a private lender. The standard repayment term for a federal student loan is 10 years. Federal student loans have a fixed interest rate. For private student loans, the repayment terms vary by lender. Private student loan interest rates may be fixed or variable.
A personal loan is a form of installment credit that you can take out for virtually any reason. You borrow a lump sum of money, then pay it off in regular intervals. Common reasons for taking out a personal loan include medical expenses, home improvement projects, debt consolidation or paying for a wedding or vacation.
A debt consolidation loan is a personal loan that you use to combine multiple debts so you have one monthly payment, often at a lower interest rate. Because more of your monthly payment goes toward the principal balance, a debt consolidation loan can reduce the time it takes to pay off debt. APRs range from 6% to 36%, depending on your credit score.
A home equity loan, or second mortgage, is a type of secured loan that lets you borrow against your home equity. You pay it off at a fixed interest rate over a set schedule. It’s similar to a home equity line of credit (HELOC) in that both let you borrow against your home equity, however, a HELOC is a type of revolving credit that typically has a variable interest rate.
Buy now, pay later services, like Klarna and AfterPay, offer a form of installment credit. You typically split the purchase price into four interest-free payments. The installment payments are billed to your debit card or credit card.
Installment loans have several advantages and disadvantages you need to know about.
A personal loan is a type of installment loan. It’s typically an unsecured loan that can be used for almost any purpose. Because personal loans usually aren’t backed by collateral, they have higher interest rates compared to mortgages and auto loans. However, they often have lower rates than a credit card.
An installment loan may hurt your credit slightly in the short term, since you may lower your average age of credit and get a hard inquiry on your credit report. However, an installment loan is typically much better for your credit than making purchases on a credit card because you’re not increasing your credit utilization.
Yes, you can typically pay off an installment loan early, but check the loan paperwork to be sure you won’t face a prepayment penalty. Also, look at the interest rates of any other debts you have. Installment loans often have lower interest rates than other types of debt, like credit cards. Tackling higher-interest debt first is typically a better bet.
Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. Send your tricky money questions to [email protected]
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