By Ben Luthi
Edited by Samuel MountjoyWhat Is an Installment Loan?
By Ben LuthiEdited by Samuel Mountjoy
Quick Answer
- An installment loan gives you a lump sum you repay in fixed monthly payments over a set term.
- Mortgages, auto loans, student loans and personal loans are the most common types of installment loan.
- On-time payments can build your credit, while missed payments can damage it.
An installment loan is a type of credit that's disbursed in a lump sum and repaid over a fixed repayment term. Most of the debt consumers carry is a form of installment credit, including mortgages, auto loans, student loans and personal loans.
As with any credit account, how you manage an installment loan can either help or hurt your credit scores. Here's how these loans work, how they compare to credit cards and what to check before you sign.
What Is an Installment Loan?
An installment loan gives you a set principal amount that you pay off over a fixed period, usually in monthly installments. A revolving credit account, in contrast, lets you borrow up to a certain limit, pay it back over time and borrow again as needed. In some cases, the limit can also go up or down over time.
The most common types of installment credit are mortgage loans, auto loans, personal loans and student loans. That said, even some credit cards, which are a form of revolving credit, offer installment plans for certain purchases.
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How Does an Installment Loan Work?
When you take out an installment loan, the terms will vary depending on the type of loan and the lender. That said, here are some general characteristics:
- Principal: This is the fixed sum you borrow, and it's typically disbursed upon approval. You generally can't change the principal loan amount after you agree to the loan terms.
- Term: After your loan is disbursed, you'll pay it back over a set repayment term, which can be anywhere from a couple of weeks to a few decades, depending on the loan type. In most cases, you can't change the term of a loan, but some lenders may be willing to modify loan terms for struggling borrowers. You may also be able to refinance the debt using a loan with a different set of terms.
- Interest: Interest is the primary cost of borrowing money. Each time you make a monthly payment, a portion of it will pay the interest that's accrued since your last payment, with the remaining amount paying down your principal balance. If your rate is fixed, your monthly payments will remain the same for the life of the loan. If it's variable, your rate—and, therefore, your monthly payments—can fluctuate over the life of the loan.
- Fees: Some installment loans come with fees, which can increase the cost of borrowing. For example, some loans charge upfront origination fees to cover the cost of processing, underwriting and funding the loan. Others may charge late fees if you miss a payment or prepayment penalties if you pay off the loan early.
Types of Installment Loans
Depending on your situation and financing needs, here are some of the most common types of installment loans you can use.
Personal Loans
A personal loan can be used for many purposes, including consolidating debt or financing a home renovation. Personal loans are usually unsecured, meaning they don't require collateral.
Personal loan interest rates usually range from 6% to 36%, depending on the lender and your credit profile. Loan amounts can be anywhere from just a few hundred dollars to $100,000 or more, with repayment terms from six months to 10 years. Some lenders charge origination fees of up to 10% or more of your loan amount.
Learn more: How to Get a Personal Loan: A Step-by-Step Guide
Auto Loans
You can use an auto loan to buy a car, using the vehicle as collateral to secure the debt. If you fail to keep up with your payments, the lender can repossess the car. Loan terms typically range from two to seven years, though some lenders now offer up to eight years.
Auto loan interest rates tend to be lower than personal loan rates, with some automakers even offering 0% APR deals to qualified new-car buyers. However, bad-credit auto loans can easily charge upwards of 20%, or even 30% in some states.
Auto loans typically require a down payment, and your loan agreement may also come with a prepayment penalty.
Learn more: What Is the Average Car Loan Length?
Student Loans
Student loans are designed specifically to cover secondary education expenses. The amount you can borrow depends on the loan program, and repayment terms may range anywhere from five to 30 years.
While federal student loans typically have low interest rates that are standardized for all borrowers, private student loans may charge higher rates based on your credit profile. That said, federal student loans come with an upfront loan fee, while private loans generally don't charge one.
Mortgages
You can use a mortgage loan to buy a home, using the property as collateral. Repayment terms typically range from 10 to 30 years, with both fixed and variable interest rate options. In general, though, mortgage loans often come with some of the lowest interest rates of all types of installment and revolving credit.
That said, you'll also need to pay closing costs and a down payment, and possibly private mortgage insurance if your down payment covers less than 20% of the purchase price of the home. If you default on your payments, the lender can foreclose on the home.
Installment Loan vs. Revolving Credit
An installment loan is closed-end credit, which means you borrow a fixed amount once and the account closes when the balance hits zero. With open-end revolving credit, paying down your balance frees that credit up to borrow again.
Access isn't always permanent, though. For instance, a home equity line of credit (HELOC) allows draws only during a set draw period, after which your balance is converted to an amortized loan with a fixed repayment schedule. Here's a quick look at the two options:
| Installment Loan | Revolving Credit | |
|---|---|---|
| How it works | You receive a lump sum upfront and repay it over a set term | You can borrow against a credit limit, repay what you've borrowed and borrow again |
| Payments | A fixed monthly amount covering principal and interest | A minimum payment that rises and falls with your balance |
| Interest | Usually fixed and charged on the full amount you borrowed | Usually variable and charged only on the balance you carry |
| Repayment terms | A payoff date you agree to when you sign | No fixed schedule, though some lines later switch to a set repayment term |
| Best for | Large, one-time expenses with a known price tag | Ongoing or unpredictable expenses |
Cost is the other practical difference. Because revolving credit provides less predictability for lenders, it tends to come with higher interest rates. That said, credit cards can still be cheaper than a personal loan, as long as you pay off your balance in full each month.
Certain revolving accounts also affect your credit differently. More specifically, your balance relative to your credit limit, known as your credit utilization rate, is a major scoring factor for credit cards.
As a result, a large installment loan may not hurt your credit as much as a maxed-out credit card.
Pros and Cons of Installment Loans
There are both advantages and disadvantages to using an installment loan, especially compared to revolving credit options. Here's what to keep in mind before you apply.
Pros
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Large loan amounts: Loan amounts can vary by loan type and lender, but you can often borrow more with an installment loan than a credit card, and you'll get all the money upfront. This is why you'll typically use an installment loan for some of the largest purchases you'll make, such as a car or a home.
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Fixed repayment term: An installment loan provides more certainty about when your debt will be paid off. In contrast, credit cards may only require a minimum monthly payment, but they don't have a fixed repayment period.
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Generally lower interest rates: While there are some exceptions, you can generally get a lower interest rate on an installment loan than a revolving credit account, especially if you have good credit. Also, most installment loans offer fixed interest rates, giving you predictable payments.
Cons
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Little payment flexibility: Because your repayment term is fixed, there's little to no flexibility with your monthly payments. On the flip side, a minimum payment on a credit card may give you more wiggle room, even if it may also result in costly interest charges.
-
Potentially higher interest charges: Although installment loan interest rates can be lower, you may end up paying more interest overall. That's because revolving credit accounts only charge interest on the amount you borrow, not the total available credit. Also, if you pay off your credit card balance in full every month, you can avoid interest charges entirely.
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Fees: It's possible to get and use an installment loan without paying any fees, but some loans may charge hundreds of dollars in origination fees or prepayment penalties. With a mortgage loan, closing costs can amount to thousands of dollars.
How Do Installment Loans Affect Your Credit?
Installment loans can help or hurt your credit, depending on several factors. Here's a look at what goes into your FICO® ScoreΘ and how installment debt plays a role:
- Payment history: Your payment history is the most influential factor in your FICO® Score, so when you make installment loan payments on time, it can help improve your FICO® Score. That said, missing a payment by 30 days or more can have a significant negative impact on your scores.
- Amounts owed: The more you borrow, the more difficult it may be to keep up with your monthly payments. As a result, high loan balances could potentially hurt your FICO® Score. Conversely, paying down your loan balances can have a positive impact.
- Length of credit history: Unlike credit cards, which you can keep open indefinitely, installment accounts are closed when you pay off the balance in full. This can have a temporary negative impact on your credit, though positive history will stay on your reports for 10 years. Also, if you open multiple loans in a short period, it could lower your average age of accounts and hurt your credit.
- New credit: Each time you apply for a loan, the lender will run a hard inquiry on your credit reports, which can have a small negative impact on your FICO® Score. That said, if you apply for an installment loan with multiple lenders in an effort to compare interest rates, those multiple inquiries may be combined into one for credit-scoring purposes.
- Credit mix: Having different types of installment loans—as well as revolving credit accounts—can help improve your credit.
Should I Get an Installment Loan?
An installment loan tends to make sense when you're borrowing a set amount for a specific purpose, and the monthly payment fits comfortably in your budget. It's generally a good idea in three situations:
- Financing a large purchase: Homes, vehicles and major home improvements cost more than most people can pay out of pocket, and spreading the cost over several years makes the purchase possible.
- Covering an unexpected expense: A medical bill or emergency repair can exceed what you have in savings, and a fixed payment is easier to plan around than a growing credit card balance.
- Consolidating existing debt: Rolling several high-rate balances into one debt consolidation loan can reduce what you pay in interest and leave you with a single due date each month.
However, there are times when borrowing costs more than it solves. A vacation, a wedding upgrade or anything else you could reasonably postpone rarely justifies years of interest payments.
Additionally, taking out a loan to cover everyday expenses without a solid budget plan could be a sign of deeper problems. Finally, if you plan to use an installment loan to consolidate credit card debt, it's crucial that you address the underlying spending issues to avoid racking up more debt.
How to Compare Installment Loan Offers
Loan offers can look similar on the surface and still differ by thousands of dollars over the life of the loan. Comparing the same set of details for every offer makes the real cost easier to see and is an important step to make sure you get the best offer for your circumstances.
Here's what to pay attention to when comparing installment loans:
- APR: The annual percentage rate combines the interest rate with certain lender fees, which makes it the single best number for comparing offers. A loan with a lower rate but a hefty origination fee can carry a higher APR than one with a slightly higher rate and no fee.
- Fees: Origination fees, documentation fees, late fees and others all add to what you owe. Also, keep in mind that origination fees may be deducted from your loan proceeds, so you may receive less than the amount you're repaying.
- Loan amount: Borrow what you need rather than the maximum you qualify for because a larger loan means more interest, even with the same interest rate.
- Term: A longer term lowers your monthly payment, but it raises your total interest cost. Meanwhile, a shorter term can reduce your overall costs, but it can put more strain on your budget. Determine the right term based on your ability to pay, then compare offers at the same term length.
- Monthly payment: Check the payment against your budget alongside your other obligations rather than on its own.
- Prepayment penalties: Some lenders charge a fee if you pay off the balance early, which could cancel out the savings you'd expect from getting ahead of schedule. Many lenders don't charge one at all, so ask for a quote on a comparable loan without the penalty.
Depending on the type of loan, lenders may let you prequalify with a soft credit inquiry, which shows your likely rate without affecting your credit scores. That makes it possible to gather several offers before you submit a formal application. For example, Experian's personal loan comparison platform can match you with loan offers based on your credit profile.
Frequently Asked Questions
The Bottom Line
Installment loans can help you achieve some of the most common and sought-after financial goals, like owning a house or car, by allowing you to pay back a purchase over a long period of time. Making installment loan payments on time and paying off the loan as agreed will help your credit.
The terms you're offered depend heavily on where your credit stands, so it pays to know that before you start shopping. You can check your FICO® Score for free through Experian to see roughly where you'd land. If needed, take some time to improve your credit before you apply to ensure you get the best rate and terms possible.
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About the author
Ben Luthi
Ben Luthi has worked in financial planning, banking and auto finance, and writes about all aspects of money. His work has appeared in Time, Success, USA Today, Credit Karma, NerdWallet, Wirecutter and more.
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