Installment loans: What they are and how they work

Heard the term “installment loan” but not exactly sure what it means? An installment loan is a common credit product. In fact, you might already have one or two of your own.

Read on to learn more about installment loans and how they work.

What is an installment loan?

Installment loans—also known as installment credit—are closed-ended credit accounts that you pay back over a set period of time. Some can be used for a variety of purposes, while others are geared toward specific financial goals like buying a house or getting a college degree.

How do installment loans work?

When you take out an installment loan, you immediately receive the money you’re borrowing or the item you’re purchasing. You pay it off—sometimes with interest—in regularly scheduled payments, known as installments. You typically owe the same amount on each installment for a set number of weeks, months or years. Once the loan is paid back in full, the account is closed permanently.

If the installment loan you’re thinking of applying for charges interest, your credit scores may play a role in the rate you qualify for. With good credit, you could be offered a lower interest rate. If you have average or below-average credit, you could still be eligible for financing, but it may come with a higher interest rate.

An alternative to an installment loan is a revolving credit account, like a credit card. Unlike installment credit, revolving credit is open-ended. This means it can be used and paid down repeatedly for as long as the account remains open and in good standing.

Types of installment loans

There are different types of installment loans, and they can be secured or unsecured. This refers to whether you need an asset, or collateral, that could be used to pay back the loan if you can’t. Each loan’s interest rate, repayment term, fees and penalties may be different. So whatever you’re in the market for, it’s a good idea to shop around.

Here are some of the most common installment loans:

Personal loans

Personal installment loans don’t have to be used for a particular purchase. They can be used to do things like consolidate outstanding debt, make home or car repairs, or pay unexpected bills. Most personal loans are unsecured.

Auto loans

Auto loans can help you pay for a new or used car. An auto loan is secured by the car you buy. Auto loans usually have fixed interest rates and repayment periods that typically range from two to seven years.

Mortgages

A mortgage is used to buy a house and is secured by the house. There are lots of different types of mortgages. The most common are repaid over 15 to 30 years.

Student loans

Whether federal or private, student loans are unsecured and help pay for undergraduate, graduate and other forms of postsecondary education. Unlike other installment loans, you usually don’t have to start repaying a student loan straight away. Instead, you can typically wait until after you graduate and find a job.

Buy-now, pay-later loans

You might have come across a buy-now, pay-later, or BNPL, loan while shopping. Some retailers offer the option at checkout. Buy-now, pay-later loans—also known as point-of-sale financing—let you spread out your payments over a few installments instead of paying for what you purchase right away. The repayment schedule can range from a few weeks to multiple years, depending on the retailer and purchase.

Payday loans

A payday loan generally describes a short-term, high-cost small personal loan that’s designed to be repaid on your next payday. The terms and structure can vary by state, payday lender and individual loan.

In exchange for a payday loan, the borrower usually gives the lender a postdated check for the full amount borrowed, plus fees. Or the borrower might authorize the lender to electronically withdraw that amount from their bank account on the due date.

Benefits and drawbacks of installment loans

Like all types of credit, an installment loan comes with pros and cons. And whether it’s the right choice for you depends on your specific situation. Here are some points to consider:

Benefits

  • Ability to cover a large expense: Installment loans can give you fast access to the money you need for bigger purchases.
  • Predictable regular repayments: With an installment loan, you know what your installment amount is going to be. And this can make budgeting easier.
  • Chance of refinancing: If interest rates fall or if your credit score improves, you might get a chance to refinance. If your installment loan is a mortgage, for example, refinancing could lower your monthly mortgage payments or shorten your repayment schedule. Keep in mind that there could be other costs and drawbacks involved with refinancing.

Drawbacks

  • Not open-ended: It’s unlikely you’ll be able to add to your loan amount if you need more.
  • Potentially long commitment: Some installment loans come with long repayment terms. This means a borrower has to commit to making regular payments over a long period of time. And be sure to read through the loan’s terms and conditions. There may be prepayment penalties for paying the loan off early.

Do installment loans hurt your credit?

An installment loan—and how you use it—could have an impact on your credit scores. And guess what? Your credit scores could also have an impact on your installment loan. Lenders take your credit history—including your scores—into account when deciding whether to offer you a loan. Your credit score can also influence the interest rates and terms you’re offered.

When it comes to how an installment loan could affect credit scores, it can be hard to predict. This is because there are different credit-scoring models from companies like FICO® and VantageScore®. And these companies calculate scores differently.

How an installment loan affects you specifically also depends on your financial situation. Plus, not all installment loans are reported to the credit bureaus. But if your installment loan is reported, it could help or hurt your credit scores when you’re:

  • Applying for a loan: Applying for a loan could trigger a hard credit inquiry. According to the Consumer Financial Protection Bureau (CFPB), these kinds of inquiries could negatively affect your credit score.
  • Using a loan: You could hurt or help your credit scores depending on whether you use the credit responsibly and make on-time payments. Your credit mix and credit utilization ratio can also change when you add a new loan. And according to the CFPB, these are all factors used to calculate your credit scores.

Keep in mind that there are other factors that can affect your credit scores. And you’ll need to keep an eye on them all if you want to get and keep good credit scores.

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