Breaking down installment loans: your friendly guide to borrowing smart
Key takeaways:
An installment loan is a simple way to borrow a lump sum of money upfront—and then make equal payments over time.
Personal loans and home equity loans are both types of installment loans.
Online lenders could make it easy to apply for a loan and find out if you're pre-approved.
Debt can be a valuable tool in managing your finances, but there are so many different kinds of loans it’s hard for anyone to keep them all straight. By learning about different types of loans, you can be confident you’re picking the right one for you, whether you’re buying or renovating a home, paying for higher education, or covering an emergency. Instead of reaching for a credit card, you might consider getting an installment loan to help you manage your finances.
Here’s what to know about getting and repaying installment loans.
What is an installment loan?
An installment loan is a simple way to borrow money. You get a fixed amount of money up front, then make equal payments—called installments—over time. Several kinds of loans work this way, so, for instance, a personal loan is one kind of “installment loan.”
If you’re taking out a personal loan, you might receive the money by check or electronically in your bank account. With other installment loans, like student loans or mortgages, the lender might pay the money to someone else for you.
You then make equal payments until the loan, including interest, is repaid.
Types of installment loans
Installment loans can be used to pay for all kinds of expenses, and lots of people have more than one installment loan at the same time. These are some of the most common types of installment loans:
Personal Loans. Personal loans are the most flexible installment loans. You can use a single loan for multiple expenses, and you don’t need to spend all the money at once. Personal loans can have shorter payment periods, often between one and five years, although longer terms are also available.
Home Equity Loans. Home equity loans have the flexibility of personal loans, but are secured by the equity in your home (to get the amount of “home equity” you have, take the current value of your home, then subtract what you still owe on the mortgage). If you’re a homeowner, you may be able to get a larger loan or pay a lower interest rate with a home equity loan. The interest on home equity loans may also be deductible on your federal tax return if the funds are used for home improvement.
Mortgages. One of the most common installment loans is a mortgage loan used to buy a home. These installment loans are usually for longer terms. The most common are 15-year and 30-year mortgages, since those loans qualify for special government protections. Mortgage loans are almost always paid directly to the seller of the home, not to the borrower, so you can’t use the money for other expenses.
Auto Loans. Like mortgage loans, auto loans are normally paid directly from your lender to the person or dealership you’re buying the car from. Most auto loans have shorter terms of five years or less.
Student loans. Installment loans are also used to pay for higher education. Unlike most other installment loans, student loans can have complicated repayment terms. For example, if your financial situation changes, you may be able to pause your payments or change your monthly payment amount. Sometimes you can even have loans forgiven by working for the government or some non-profit organizations.
How installment loans impact your credit
When you apply for an installment loan, the lender checks your credit report. That’s called a “hard” credit check, and it can lower your credit score by a few points or more.
If you’re approved, the new loan appears on your credit reports, which show the original loan amount and the amount you owe.
By making your installment loan payments on time, you’ll build a payment history which could improve your credit over time. Even after the loan has been paid off, those payments remain on your credit report for 10 more years, impacting your credit profile.
Another factor that influences credit is the variety of credit accounts you have. Managing different kinds of loans can improve your credit standing and widen your access to new credit accounts.
Credit cards show up on your credit report as open-ended or “revolving” loans. That means you can borrow up to your credit limit multiple times (by paying down your balance each time). Installment loans show up on your report as closed-ended loans, since after you repay the loan, the account is closed. Having both kinds can help your credit standing over time.
Advantages of installment loans
Quick funding. If you need money fast, an installment loan can get you cash faster than opening a new credit card. Once your application is approved, you could have your money in as few as 3 business days.
Flexible uses. You can use a personal loan for expenses, including at businesses that require you to pay with cash, or when you want to avoid credit card processing fees.
Pay for large purchases over time. If you have emergency expenses like car or home repairs, you may not have time to save the money to cover them.
Fixed monthly payments. Unlike with a credit card, your monthly payment amount won’t change over time, which can make budgeting easier.
Predictable repayment term. If you make all your payments on time, your loan will be completely paid off on a fixed schedule. If you make extra payments, you can repay your loan faster and save money on interest over time.
Build credit history. Your on-time payments should help your credit profile, even after the loan is repaid.
Simple fees. Installment loans don’t typically charge annual fees or other tricky fees, like some credit cards do.
Drawbacks of installment loans
Fixed loan amount. If you need to borrow more in the future, you’ll have to take out another loan.
Potential fees. Make sure you understand all the fees you’ll be charged before you take out an installment loan.
Not everyone qualifies for a low interest rate. Your interest rate depends on your income, assets, and credit history. You can save money on interest by not borrowing more than you need. You could also shop for lenders offering interest rate discounts.
How to get an installment loan
Get pre-approved
Online lenders should let you see if you’re pre-approved for a loan without hurting your credit standing. Look for the right combination of loan amount and interest rate for your needs.
What to expect when you apply
Once you apply, your lender looks at your credit report to verify the information you provided, like income, assets, and employment. You may be asked to provide recent bank statements or pay stubs.
Factors lenders look at
Your credit profile is just one factor lenders look at when deciding how much you can afford to borrow, and what interest rate you’re charged. Another important factor is whether you have enough income to afford the monthly payments. A borrower with a high income and poor credit may be able to borrow more than someone with a low income and perfect credit. Make sure what you need to do to maximize your odds for approval.
Funding time
If you’re approved, once your information is verified and you sign the loan documents, you may receive your loan in as few as 3 business days.
Frequently asked questions
How is revolving credit different from an installment loan?
With revolving credit like credit cards, you can pay down your balance and then borrow more money as often as you want. Installment loans are a fixed loan amount you receive upfront. If you want to borrow more money in the future, you have to take out a second loan.
Are installment loans bad for credit?
Applying for installment loans can temporarily reduce your credit standing. Over time that effect goes away and a history of on-time payments benefits your credit profile. Even after the loan is repaid, your on-time payments will continue to boost your score for 10 years.
What happens if you pay off an installment loan early?
You can save money on interest and pay off your loan early by making extra payments. Once the loan is repaid, it remains on your credit report for 10 years. Check to make sure your loan doesn’t have prepayment penalties that reduce the amount you save.
