Installment loans are helpful tools that allow consumers to purchase big-ticket items, such as homes and automobiles, and pay over time via regularly scheduled payments, otherwise known as installments. Each scheduled payment will include a portion of the borrowed principal amount and interest on the outstanding loan balance.
An installment loan offers various strengths and weaknesses and should not be considered lightly. Additionally, the amount of money a lender is willing to loan will vary from one borrower to the next based on key factors. Different lenders may use other lending criteria, as well. Here’s what you need to know about installment loans and how to make them work best.
What is an Installment Loan?
An installment loan is a loan for a specific amount of money to be repaid according to prescribed terms and within a set timeframe. It is different from revolving credit in that there is a set a date for loan repayments to begin and end. With revolving credit, there is no defined start and finish date, and your monthly payments vary according to the balance of your debt. Also, unlike revolving credit, the amount borrowed in an installment loan is fixed. Because of this, you know what your monthly payments will be and can budget accordingly.
Depending on the type of installment loan you have and the total amount of the loan, you may need to secure the loan with collateral. For instance, when you borrow enough to purchase a home with an installment loan, the house itself often serves as collateral for the loan. However, if you are taking out a personal loan, the lender may or may not require collateral to secure the loan based on your credit score and various other factors.
How Installment Loans Work
When you take out the loan, you receive a lump sum with installment loans. This allows you to make the purchase you desire, such as a home, automobile, boat, etc. Then you begin making scheduled payments according to your specific installment loan terms. This is usually in the form of fixed monthly, bi-weekly, or weekly payments for a specified number of payments. Home mortgages, for instance, are installment loans typically repaid over terms of 10, 15, or 30 years. Sometimes, the term can be shorter or longer, but you will know from the start how many payments you will have to make before the loan is repaid in full.
Benefits
There are quite a few benefits worth considering when taking out installment loans. You’ll want to remember these key benefits when comparing your options with other types of loans and financing available.
- Installment loans allow you to pay for large purchases over time.
- Payment amounts and duration are set in advance, so you can budget accordingly.
- Most times, you can save money on interest through early loan repayment. You should check the terms of your loan, as some lenders impose early repayment penalties that may negate the potential savings.
- You may be able to refinance the loan for more favorable interest rates, monthly payments, or terms as market conditions change or your credit situation and/or financial means evolve.
As you can see, installment loans are beneficial for the right situations.
Drawbacks
In addition to the benefits, though, it is essential to consider the drawbacks of this type of loan. Installment loans are only the right choice for some financial needs. An installment loan alternative might better serve your needs in plenty of situations. Consider these potential drawbacks before deciding if an installment loan suits you.
- Installment loans require a lengthy commitment. With the average auto loan term approaching 70 months for a new car and a home mortgage term of 360 months, this is a payment you’ll make for a long time.
- The installment loan is for a specific amount and is delivered in one lump sum payment. For those who aren’t sure how much money they need (such as home improvement, financing an education, etc.), this can be particularly limiting compared to other installment loan alternatives.
- Interest payments are likely. Most installment loans require interest. Whether that is a variable or fixed rate depends on the type of loan and the terms of your specific loan. The better your credit score, the more favorable interest rates you’ll be able to secure, but interest payments are a likely reality for most consumers who take out installment loans.
Consider these things when exploring your options for financing major purchases, consolidating debt, and making other impactful financing decisions.
Tips for Using Installment Loans Responsibly
Using your installment loan responsibly will have a massive impact on your credit score and ability to obtain future credit. Most lenders report installment loans to various credit bureaus. This includes the loan amount, how much you owe on your loan, how much you’ve paid, and how timely your payments have been. For instance, a history of on-time payments over several years will reflect favorably on your credit report, while even a single late payment can negatively impact you. Repaying the loan in full also reflects favorably, helping to increase your credit score so you can secure better interest rates on future loans.
Alternatives to Installment Loans
A line of credit is a better choice for many people facing uncertain expenses. These loans allow you a “well” of credit from which you can borrow multiple times until you’ve reached your credit limit. This is considered revolving credit, as the amount you must repay varies according to how much you’ve borrowed against your line of credit. Common “lines of credit” examples include home equity lines of credit (HELOCs) and credit cards.
The better you understand installment loans and how they work, the wiser choices you can make when borrowing to meet your short or long-term purchasing needs and your overall financial goals.