Installment loans are a type of loan that allows you to finance large purchases or unexpected expenses and pay them off over time with a series of fixed payments, usually monthly. Unlike options such as payday loans or credit cards, installment loans have a set repayment schedule and interest rate with predictable, stable payments.
Here’s what you should know about how installment loans work and the benefits and drawbacks of this type of loan if you are thinking about borrowing.
[Read: Best Personal Loans.]
How Does an Installment Loan Work?
Installment loans are a common way to borrow money. They can give you access to cash for a major purchase or help you consolidate debt. With an installment loan, you borrow a set amount of money and repay it, often with interest, in regularly scheduled payments — known as installments — over a fixed period.
Borrowers typically make equal payments, often monthly but sometimes biweekly or quarterly, until the loan is paid off and the account is closed.
If you pay interest on an installment loan, the rate may depend on your loan type and your credit score. The total interest paid over the loan’s life depends on the interest rate and the term length. Generally, you’ll pay more interest with a longer loan, and loans with shorter terms usually have lower interest costs but higher monthly payments.
Installment loans can be secured, meaning they require the borrower to provide collateral, or unsecured, and may have fixed or variable interest rates.
Types of Installment Loans
These are some of the most common types of installment loans for consumers:
— Mortgages. A mortgage is a loan used to finance the purchase of a home and secured by the home as collateral.
— Personal loans. A personal loan is typically an unsecured installment loan you can use for various purposes, such as consolidating debt, making home repairs or paying for medical expenses.
— Debt consolidation loans. Usually a type of personal loan, a debt consolidation loan rolls multiple debts into a single, more manageable payment, often with a lower interest rate.
— Student loans. You can use federal or private student loans to finance higher education, and installment loan payments may be deferred until after graduation.
— Auto loans. Car buyers often use these secured installment loans to finance the purchase of a car, with the vehicle serving as collateral.
— No-credit-check loans. These loans don’t require a hard credit check, instead basing approval on factors such as income or collateral.
— Buy now, pay later loans. Buy now, pay later, or BNPL, allows you to purchase goods or services and pay for your purchase over time, sometimes without interest. Terms vary depending on the payment plan you choose.
— Credit-builder loans. The amount you borrow is held in an account while you make regular payments that can help you build or rebuild your credit. You receive the funds once the loan is paid.
Secured vs. Unsecured Loans
Installment loans can be secured or unsecured. A secured installment loan is backed by collateral, such as a car or house that the lender can seize if you fail to repay the loan.
“Secured debt is secured by a tangible asset,” says Kyle Enright, president of lending at digital lender Achieve. “If you miss payments for any reason, you risk losing the asset.”
Collateral reduces risk for lenders, and that typically translates to lower interest rates and larger borrowing amounts than unsecured loans. Unsecured loans are riskier because they do not require collateral and typically come with higher interest rates, especially for bad-credit borrowers.
Pros and Cons of Installment Loans
Installment loans can offer predictability, affordability and the possibility to build credit. But depending on the loan, you could face high interest rates and risk losing your collateral. You’ll want to weigh the pros and cons to determine whether an installment loan is the right choice for you.
— Predictable payments. Installment loans have a fixed repayment schedule and interest rate, which makes budgeting for payments easier.
— Large loan amounts. Access cash for big purchases, such as a home or a car.
— Refinancing opportunities. If your credit or rates have improved since you first borrowed, you might have a chance to refinance your loan. This could lower your monthly payment or shorten your repayment schedule, but other costs and drawbacks can be involved.
— Credit building. Making on-time loan payments can improve your credit score.
— Potentially high interest rates plus fees. Depending on the lender and your creditworthiness, you could pay high interest rates. Some loans also include origination fees that are a percentage of the loan amount and vary by lender and loan type, among other factors.
— Long commitments. An installment loan may have a long repayment term, which means you must make monthly payments over a long period.
— Fixed credit limits. Installment loans are closed-end credit, and you usually can’t borrow more unless you get a new loan.
— Prepayment penalties. You may be hit with these fees from your lender if you pay back your loan ahead of schedule.
[Read: Best Mortgage Lenders.]
Applying for an Installment Loan
Follow these basic steps to apply for an installment loan:
1. Check your credit report and credit score. Before applying for a loan, look at your credit report to address any errors or need for improvement. Your credit score can give you an idea of the types of loans you might be able to access.
2. Determine how much you need to borrow. Calculate what you can afford to repay each month.
3. Shop lenders. Research and compare lenders by getting prequalified for loans to find the best loan options and interest rates. Many lenders allow you to prequalify online to view potential loan options with a soft pull that won’t hurt your credit score.
4. Gather necessary documentation. Depending on the lender, you may need to provide W-2 forms, pay stubs, tax returns, bank statements and personal identification documents.
5. Complete the application. Fill out the lender’s loan application and provide all required information and documentation. You can do this online, but don’t overlook going into a bank or credit union branch to apply in person, says Bill Maurer, director of the Institute for Money, Technology and Financial Inclusion at the University of California, Irvine. A banker can also help you find the right installment loan. “You can hunt around online and see what rates and terms are, but if something looks too good to be true, it probably is,” Maurer says.
6. Wait for loan approval. The lender will review your information and determine your loan eligibility. You may see a short-term dip in your credit score from the hard inquiry when the lender checks your credit.
7. Review and sign the loan agreement. Carefully review the loan agreement, and make sure you understand the terms and conditions before signing.
Once the agreement is signed, the funds will be disbursed to your bank account. Make sure to pay your loan on time and in full according to the repayment schedule outlined in the loan agreement.
How Installment Loans Can Affect Your Credit
An installment loan can help or hurt your credit, depending on how you manage the loan.
Opening an installment account and making on-time payments can strengthen your credit in two ways: You establish payment history and diversify your credit mix. But if you miss payments or default on a loan, you can damage your credit score and make obtaining credit difficult in the future.
Payment history is the most important factor of your FICO score, making up 35% of your score. On-time payments can help you build, rebuild or maintain good credit, but late payments can damage your credit score for as long as seven years.
Because installment loans require a monthly payment, you must ensure that you pay every bill on time, Maurer says. “A two-year loan gives you 24 opportunities to screw up,” he says.
Stay on top of loan payments and you can help, rather than hurt, your credit. An installment loan can also help your credit by adding variety to your mix of accounts. Your credit mix makes up 10% of your FICO score.
[Read: Best Debt Consolidation Loans.]
Alternatives to Installment Loans
If you’re considering installment loans but want to look at other options, consider these alternatives:
— Credit cards. Credit cards offer a revolving line of credit that can be paid off over time. However, credit card balances can grow with interest charges even when you don’t make purchases. “If you are absolutely certain you can pay off the entire balance in full — on time — at the end of the billing cycle, a credit card might be an option for a large purchase,” Enright says. “However, given current interest rates on credit cards, it’s not a good option if you can’t pay off the entire amount in full.”
— Payday alternative loans, or PALs. Credit unions offer PALs as an alternative to payday loans. They typically allow you to borrow up to $1,000 and have lower interest rates and longer repayment terms than payday loans.
— Friends and family members. Borrowing money from friends or family members can be a good alternative to traditional loans, but have a clear repayment plan in place to avoid damaging relationships.
— Side hustles. If you need to make extra money, consider having a side hustle, such as freelancing or selling items online.
— Negotiating payment plans. If you’re struggling to pay your debts, contact your creditors to discuss payment plans or hardship programs that may be available.
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How Do Installment Loans Work? originally appeared on usnews.com