- With installment loans, a borrower receives a lump sum of money that must be repaid in fixed amounts over a set period of time.
- Mortgages, auto loans, and personal loans are common examples of installment loans.
- Missed or late payments on an installment loan are likely to have a negative effect on your credit score.
An installment loan is a common type of loan that is repaid in regularly scheduled installments. Installment loans can be personal or business loans. They're typically used to finance a new home or car or to make another big purchase.
In this quick guide we'll cover what is an installment loan, potential pros and cons, and how one can affect your credit score.
Installment Loan Definition
When a borrower is approved for an installment loan, they typically receive a lump sum of money to be repaid over time with regularly scheduled payments over the course of months or years. Typically, the payments are made on a monthly basis.
Every installment payment is made up of two parts: 1) repayment of part of the amount that you borrowed — also known as the "principal" of the loan — as well as 2) interest on the money borrowed.
With all installment loans, the amount you pay is determined by several factors, such as the loan amount, the interest rate the lender charges, and the term — or length — of the loan.
With some installment loans, you'll pay a fixed dollar amount every month. However, with others — particularly mortgages with variable interest rates — the amount you pay may change significantly from month to month.
It's worth noting that, with some installment loans, such as mortgages, the ratio of interest to principal is higher during the first few years of paying back the installment loan. As you pay over the years, the percentage of the payment that covers interest decreases.
Types of Installment Loans
There are many types of installment loans. They include:
Auto Loans
These loans finance the purchase, refinance, and lease buyout of a vehicle. If you fail to keep up with the payments, the lender may reclaim the vehicle as a last resort.
Mortgages
Upon receiving a mortgage loan, you'll receive a lump sum that covers the purchase of a house minus any down payment. Most mortgages are repaid over a period of 15 or 30 years.
Your mortgage payment may also include payments for home insurance, private mortgage insurance (PMI), and property taxes. This may lead to fluctuating monthly payment amounts.
In addition, mortgages with variable interest rates may also cause your payment to change. If you fail to keep up with the required payments, the home may be foreclosed upon.
Personal Loans
Personal loans are installment loans that can be used for many purposes, from consolidating your debt to paying for a wedding. You can also use personal loans to pay for home improvements, vacations, moving costs, or other major purchases.
Student Loans
Student loans are installment loans that cover the cost of higher education. Interest rates for student loans may be either fixed or variable.
When you receive a student loan, you may have the option to defer repayment until after graduation. However, interest will still accrue while you remain in school and will be added to the principal loan amount at the end of the deferment period.
Secured vs. Unsecured Installment Loans
Some installment loans are secured, meaning the borrower must offer collateral to back them up, while others are unsecured. For example, mortgages and auto loans are typically secured, which means the house and vehicle in question act as the collateral.
If you fail to keep up with payments for secured loans, the lender may take away the collateral. This could result in a home entering foreclosure or repossession of the vehicle.
On the other hand, unsecured loans do not require collateral. A common example of an unsecured loan is a personal loan.
Unsecured loans are not backed by collateral that the institution can claim if the borrower fails to keep up with payments. They’re based solely on the borrower's perceived ability to repay the loans. That may make unsecured loans more challenging to qualify for compared to secured loans.
Unsecured loans also generally involve higher interest rates due to the extra risk shouldered by the lender.
Pros and Cons of Installment Loans
Installment loans can make a large purchase possible if you don't have the cash on hand to cover it. However, installment loans have benefits and drawbacks. It's important to consider both the potential pros and cons of installment loans before applying.
Benefits of Installment Loans
Here are some of the advantages of taking out an installment loan:
- Over time, it can help you pay off a big purchase, such as a new home or vehicle.
- If you receive a fixed interest rate, the amount due every month will be the same, making budgeting easier.
- Paying on time every month can help you build your credit.
- Depending on the terms of your loan, you may be able to pay the loan off early.
Drawbacks of Installment Loans
Here are some common downsides of taking out an installment loan:
- The lender may charge application and origination fees.
- Missed or late payments will or could result in a lower credit score if habitual.
- You may have to pay a higher rate due to variables such as credit score and income.
- You may "lose" money to interest payments versus paying for a purchase with cash.
Installment Loans vs. Revolving Lines of Credit
Another common type of loan is the revolving line of credit. As with installment loans, revolving lines of credit require the potential borrower to meet certain credit requirements. There are also similar penalties for missing or defaulting on payments.
However, unlike installment loans, revolving lines of credit provide both borrowing and payment flexibility. You can borrow funds up to an approved credit limit when needed and pay borrowed balances in full or through monthly payments. Payment amounts will determine how much credit is available for you to borrow again up to the credit limit.
Credit cards are an example of revolving lines of credit. However, other examples include personal lines of credit (PLOC) and home equity lines of credit (HELOC).
As with installment loans, some forms of revolving credit may be secured. This includes the HELOC, in which the home is used as collateral.
Credit cards are typically unsecured, although there are secured credit cards that require cash deposits as collateral.
How Installment Loans Affect Your Credit Score
Usually, when you apply for an installment loan, the lender will perform a hard credit check. Also known as a "hard inquiry" or "hard pull," this involves taking a complete look through your credit report to determine creditworthiness. The lender will look at past and current loan and credit card accounts, paying attention to your payment history and balances. This helps the lender decide whether to risk granting you a loan.
Hard credit checks will appear on your credit report for two years. In addition, it may temporarily lower your credit score. According to FICO, one of the leading credit-scoring companies, each credit inquiry typically takes fewer than five points off your score.[1]
Rest assured, if you're shopping around for mortgages, multiple credit checks from mortgage lenders made within 45 days of the first hard check are reported as a single inquiry.[2]
In addition, missed or late payments may have a negative effect on your credit score. That's because payment history accounts for as much as 35% of your total credit score.[3]
Although one or two late payments here and there may not lower your credit score, it will likely take a severe hit if late or missed payments become a habit.
Responsible Borrowing Tips
If you take out an installment loan, here are some best practices to follow:
- Set up an automatic pay plan: Many installment loan lenders will allow you to set up "auto pay." As long as you maintain the necessary funds in a linked checking or savings account, this will prevent any late or missed payments.
- Borrow only what you need: When applying for a personal loan, it may be tempting to request extra funds. However, taking on more debt than you can manage can lead to financial trouble.
- Shop around for interest rates: Look for installment loans with lower interest rates. It may be worth looking at loans with shorter terms and higher monthly payments so that less money is "lost" on interest.
- Pay extra, if possible: If you can, pay more than the minimum payment every month. This may help you pay off the principal of the loan faster while potentially saving on interest charges. However, be aware that some lenders charge penalties for prepayments, so know your loan terms thoroughly.
The Bottom Line: Understanding Installment Loans
Understanding how installment loans work is important before you apply for one. Always be sure to read the fine print, and feel free to ask the lender questions about their policies.
Installment loans may help you afford a big purchase. But they may also seriously affect your finances if you don't make the required payments on time. Taking advantage of an auto-pay system may help you prevent missed payments and negative marks on your credit report.
