How Installment Loans Work—and Are They Right for You?

“Installment loan” is a broad, general term that refers to the overwhelming majority of both personal and commercial loans extended to borrowers. Installment loans include any loan that is repaid with regularly scheduled payments or installments.

If you are thinking about applying for an installment loan, there are some pros and cons to consider first. Here’s what you need to know before taking one out.

What Is an Installment Loan?

An installment loan provides a borrower with a fixed amount of money that must be repaid with regularly scheduled payments. Each payment on an installment debt includes the repayment of a portion of the principal amount borrowed and the payment of interest on the debt.

The main variables that determine the size of each loan payment include the amount of the loan, the interest rate charged by the lender, and the length or term of the loan. The regular payment amount, typically due monthly, stays the same throughout the loan term, making it easy for the borrower to budget in advance for the required payments.

Types of Installment Loans

Common types of installment loans include auto loans, mortgage loans, personal loans, and student loans. Other than mortgages, which are sometimes variable-rate loans, where the interest rate can change during the term of the loan, nearly all installment loans are fixed-rate loans, meaning that the interest rate charged over the term of the loan is fixed at the time of borrowing.

Secured vs. Unsecured Installment Loans

Installment loans may be either secured (collateralized) or unsecured (non-collateralized). Mortgage loans are collateralized with the home that the loan is being used to purchase, and the collateral for an auto loan is the vehicle being purchased with the loan.

Some installment loans (often referred to as personal loans) are extended without collateral being required. These unsecured loans are made based on the borrower’s creditworthiness, usually demonstrated through a credit score, and their ability to repay as indicated by their income and assets.

The interest rate charged on an unsecured loan is usually higher than the rate on a comparable secured loan, reflecting the higher risk of non-repayment that the creditor accepts.

Applying for an Installment Loan

A borrower applies for an installment loan by filling out an application with a lender, usually specifying the purpose of the loan, such as the purchase of a car. The lender should discuss with the borrower various options, such as the down payment, the term of the loan, the payment schedule, and the payment amounts.

If an individual wants to borrow $20,000 to finance the purchase of a car, for example, the lender is likely to explain that making a higher down payment could get the borrower a lower interest rate, or that the borrower could obtain lower monthly payments by taking out a loan for a longer term. The lender will also review the borrower’s creditworthiness to determine the amount of credit and the loan terms that the lender is willing to offer.

The borrower ordinarily pays off the loan by making the required payments every month. Borrowers can usually save interest charges by paying off the loan before the end of the term set in the loan agreement, unless there are penalties for doing so.

Advantages and Disadvantages of Installment Loans

Installment loans are flexible and can easily be tailored to the borrower’s specific needs in terms of the loan amount and the length of time that best matches the borrower’s ability to repay it. These loans let the borrower obtain financing at a substantially lower interest rate than is usually available with revolving credit, such as credit cards.

For longer-term loans, an additional disadvantage is that the borrower might be stuck making payments at a higher interest rate than the prevailing market rate at the time. However, the borrower may be able to refinance the loan at the prevailing lower interest rate.

The other main disadvantage of an installment loan stems from the borrower being locked into a long-term financial obligation. At some point, circumstances may make it impossible for the borrower to keep up with the scheduled payments, risking default and possible forfeiture of any collateral used to secure the loan. For that reason, it makes sense to borrow no more than you absolutely need and to opt for a shorter term over a longer one if you can afford the payments.

How Installment Loans Affect Your Credit Score

Paying off an installment loan on time is an excellent way to build your credit. Payment history is the single most important factor that contributes to your credit score, and a long track record of on-time payments is good for your credit rating.

On the other hand, your credit score can take a hit if you don’t make timely payments or you default on the loan—which is a major red flag in the eyes of lenders.

The Bottom Line

An installment loan can help you finance a major purchase, such as a car or home. Like any loan, there are pros and cons to consider. Advantages include flexible terms and lower interest rates than credit cards, while a major disadvantage is the risk of defaulting on the debt if you’re unable to repay it.

If you decide to take out an installment loan, shop around for installment loans and compare rates and terms offered by multiple lenders before signing on the dotted line.