What Is An Installment Loan?

An installment loan is a way to borrow money, typically for a single large purchase such as a car, house or college education. After getting approved by a lender, the borrower receives a lump sum and repays the loan over a set term in monthly payments, or installments.

Installment loans work differently than revolving credit, such as credit cards, which provide a credit line to continuously borrow from rather than a single amount to repay. Revolving credit allows the money to be borrowed again once it’s paid off, whereas an installment loan account is closed once it’s repaid.

If you’re considering taking out an installment loan, here’s what you need to know about what they are and how they work.

Types of Installment Loans

Installment loans come in two main categories: secured and unsecured.

A secured loan requires collateral—someone’s asset or property—as security against the loan. The lender can take ownership of a loan’s collateral if you fail to pay; that means that if you can’t repay your auto loan, for instance, the lender can repossess your car. Personal loans are one type of installment loan that is  typically unsecured, which means personal loans generally require no collateral.

Here are the most common types of installment loans you’ll encounter:

• Personal loans: These installment loans can be used for a variety of purposes, such as debt consolidation, medical expenses, home renovation or a wedding. You can find them at traditional financial institutions like banks and credit unions in addition to online-only lenders that specialize in speedy transactions. Personal loans come in a wide range of amounts, and the interest rate can vary greatly depending on your credit.
• Auto loans: These installment loans are used when buying a vehicle. Since they’re secured with the car as collateral, ownership of your car is at risk if you can’t make your payments. But as a result, auto loans typically have much lower interest rates than unsecured loans. For example, in the fourth quarter of 2019, the average interest rate on a 48-month new car loan was 5.45%, according to the Federal Reserve. On a 24-month personal loan, the average interest rate was 10.21%.
• Mortgages: Mortgages are secured installment loans used to finance the purchase of a house. Similar to auto loans, your home is used as collateral to protect the lender, which keeps mortgage interest rates lower than unsecured loan rates. But it also means your home can be taken from you if you can’t meet your loan’s obligations.
• Student loans: These are installment loans that pay for higher education and can be issued by the federal government or a private lender. Interest rates, terms, repayment options and forgiveness programs vary depending on whether they’re federal or private student loans.
• Payday loans: Payday loans are a type of installment loan advertised as a way to help borrowers get by until they receive their next paycheck. But with sky-high interest rates and fees, they’re known to trap consumers in cycles of debt and are considered by many to be a form of predatory lending. Consider alternatives instead.

Benefits and Drawbacks of Installment Loans

Installment loans aren’t inherently good or bad. Whether they’re helpful or harmful to you depends on your credit, current financial situation and borrowing needs.

As a borrowing option, installment loans have several potential benefits:

• Predictable monthly payments: If you’re on a tight budget, knowing you’ll owe the same amount each month can help you plan out spending. Since installment loans are made using a set term, such as two years or five years, you also know when you’ll be done paying them off.
• Fixed interest rate: Many installment loans have fixed interest rates. That adds another layer of predictability, since you likely know your rate won’t increase like a variable rate might. Some installment loans, such as private student loans, let you choose between a fixed and variable interest rate. Variable rates are typically only worth choosing if you plan to pay off your loan quickly and can avoid potential rate increases in the future.
• Higher credit limits than plastic: You can typically borrow more money with an installment loan than with a credit card. In many circumstances, if you need to make a large purchase, a loan could be a better option. But home equity lines of credit, which is a type of revolving credit—not an installment loan— could also come with a higher borrowing limit than credit cards. Generally, you can borrow up to 85% of your home’s value, minus what you owe on the mortgage.

Installment loans can also have these downsides:

• Lack of flexibility: If you need to borrow a set amount—say, to buy a car—an installment loan is ideal. But if you may need additional funds later, or if you’re not sure how much money you’ll need, you might be better off using revolving credit due to its flexibility. Fixed interest rates can also be a downside; while they mean consistent monthly payments that can make budgeting easier, your rate won’t decrease if market conditions change.
• Potentially high rates for some borrowers: Depending on your credit and the installment loan type you’re considering, average rates could be higher than rates on revolving credit lines. For instance, those with excellent credit may be able to qualify for personal loans with interest rates as low as 4.99%, but if your credit is fair or poor, the rates you can qualify for can be very steep—as high as 36%.

By contrast, the average credit card interest rate on all accounts in the fourth quarter of 2019 was 14.87%, according to the Federal Reserve. Those with poor credit will likely qualify for higher rates, however.

Installment Loans vs. Revolving Credit

Installment loans and revolving credit are two ways to borrow, but they work very differently. You can think of installment loans as a one-time transaction allowing you to borrow a set amount, whereas revolving credit—including home equity lines of credit (HELOC) and credit cards—is more fluid.

When you’re approved for a credit card, for example, you’re given a credit limit that you can continue to borrow from as you pay off your charges. If you carry a balance, you’ll pay interest on that amount, and only that amount, and you’ll owe a minimum monthly payment to the issuer.

Say you get a new credit card with a $5,000 credit limit. If you carry a balance of $1,000, you pay interest only on that $1,000—not the $5,000. And once you repay that $1,000, you can borrow up to $5,000 again.

This offers less predictability than an installment loan, but more flexibility. Interest rates on credit cards are typically higher than on many types of loans, particularly if you can qualify for the lowest installment loan rates. If you only ever make the minimum payments on a revolving credit account, you can become trapped in debt. This makes revolving credit best for emergencies, or as a way to pay off occasional large purchases over time, like furniture or a television, that aren’t big enough to warrant taking out a loan.

How Installment Loans Affect Your Credit

As is true with any form of borrowing, taking out an installment loan can impact your credit either positively or negatively. Here’s how:

• Payment history: Your payment history is the largest factor in your credit score, making up 35% of it in the FICO credit scoring model. If you make all installment loan payments on time, that will help strengthen your credit. On the flip side, if you make late payments or fall behind and miss them, your credit will suffer.
• Credit mix: Having a mix of different forms of credit can benefit your credit score, too. If you don’t currently have a loan, adding one to your credit report can give you a boost, but only after you’re approved. It’s not wise to take out a loan that you’ll have to fit into your budget just for this purpose. That’s also because an application for a new line of credit will lead to a hard inquiry on your credit report, causing a temporary dip in your score.
• Credit utilization: Your credit utilization ratio is a significant factor in your credit score, contributing around 30% of it, according to FICO. This figure indicates how much of your total available credit you’re using at any time. Using too much of it can hurt your score and cause lenders concern that you’re overburdened with debt. If your credit utilization rate is already high due to large credit card balances or other loans, adding a loan to your credit file could cause your score to drop.

How to Know If an Installment Loan Is Right for You

Taking out an installment loan will both affect your budget and have a long-term impact on your credit.

When you receive a loan offer, carefully assess whether you have room in your budget for a new monthly payment. Consider: Will you still be able to make your payments if you have a financial emergency? Do you have a savings buffer to help in those situations?

If you’re uncertain that you can comfortably pay off the loan within the repayment period, talk with your lender about options for updating the offer. Perhaps you need a longer term so your monthly payment will be lower, or a smaller loan.

Another option is to consider loan alternatives, such as a credit card, for certain purchases. While credit card interest rates can be higher than personal loan rates, for instance, many have introductory offers of 0% APR for 12 months to 18 months, giving you the ability to pay off your balance without paying interest.

Before using a 0% APR credit card, however, make sure you take note of the regular APR and that you can afford payments if you’re still carrying a balance when it kicks in. Use installment loans or credit cards responsibly and you’ll have the opportunity not only to meet your financial goals, but to keep your credit strong, too.