What is an Installment Loan? How Fixed-Term Financing Works

An installment loan is a loan with a fixed repayment term, meaning that there is a specific end date to the loan. When you sign up for an installment loan, you know exactly how many payments you will have to make. The exact end date for the loan may change if you defer your loans, but, in general, it will stay the same.

Installment loans can have either fixed or variable interest rates, depending on the loan type. Terms will also vary based on the kind of loan you sign up for.  

Revolving and installment loans are the two primary types of loans. A revolving loan is a type of loan that does not have a specific end date, such as a credit card.  

Revolving loans include a credit limit that can be refilled as you pay back the money. But when you borrow money with an installment loan, you cannot receive any more funds. If you need more money, you’ll have to take out a new loan.

Installment loans can come in several forms, and knowing how each of them works can help you save money. Here are the most popular types:

Personal Loans

A personal loan is an unsecured installment loan, which means that there is no collateral behind the loan. This is different from other types of installment loans, such as mortgages or auto loans. If you default on a personal loan, the lender can’t seize any of your personal property.

A personal loan may be provided for several different reasons, including:

Most personal loan companies do not let you use the funds for business or education-related expenses or to pay off existing student loans. In those scenarios, you’ll have to take out a business loan or student loan. However, each personal loan company has its own policy on what you can use the money for.

Personal loans usually have repayment terms starting as little as one or two years and going as high as seven years. In general, interest rates for personal loans will vary depending on the repayment term. Shorter terms have lower rates — and vice versa.

Like any other kind of loan, interest rates for personal loans vary based on current market interest rates. Personal loans tend to have fixed interest rates, which means that the rate will stay the same for the entire loan.

One way many people use a personal loan is to pay off an existing loan with a higher interest rate. This is also known as debt consolidation. For example, let’s say you owe $25,000 on a credit card with 20% APR. If you can qualify for a personal loan with a 10% interest rate and a two-year term, you may save a hefty amount on total interest in the long term.

Personal loans can start at $1,000 and go up to $100,000 or more, but many lenders cap loans at $50,000. The exact loan amount you qualify for depends on your credit score.

Auto Loans

If you’ve ever purchased a car, you may have used an auto loan — an installment loan used to finance a vehicle. It’s a type of secured loan, which means that the vehicle is used as collateral in case you default on the loan. If that happens, the lender can repossess your car.

Auto loans can originate directly from a dealership’s financing wing or from a separate lender, such as a traditional bank or credit union or an online lender. Consumers can often find better deals if they go with third-party financing instead of relying on a dealer to provide the loan.

Repayment terms from auto loans range from two years to seven years.

Rates will vary heavily depending on the term, amount borrowed, type of car and more. The longer the loan term, typically the higher the interest rate. Interest rates on auto loans are often fixed, so the monthly payment won’t change during the loan term.  

Auto loans may or may not require a down payment, depending on the lender. If you provide a down payment, your monthly payments will decrease. Some borrowers use their trade-in vehicle’s value as their down payment.

Auto loans may allow cosigners, so the borrower could possibly qualify for a lower interest rate or higher loan amount based on their cosigner’s credit profile.

Mortgages

Mortgages are the most well-known type of installment loan. They’re a secured loan, which means the home itself is used as collateral on the loan. Borrowers who default on mortgages can have their homes seized by the lender.

For most people, mortgages are the longest type of installment loan they will have. Repayment terms from mortgages can start at 10 years, but last as long as 40 or 50 years in high-cost-of-living areas. The typical mortgage term is either 20 or 30 years.

Most mortgages have fixed interest rates, but you can also apply for an adjustable-rate mortgage (ARM). An ARM is like a combination of a variable and a fixed-rate loan. 

The rate will remain the same for the first few years, and then switch to a variable-rate loan. Some consumers prefer ARMs if they only plan to stay in the home for a short amount of time before moving.

Interest rates for mortgages will depend on several factors including the market rate, your credit score, and down payment, among others.

Mortgages almost always require a minimum down payment, which can vary between 3.5% and 10%. The down payment requirement depends on the type of loan and your credit score. The higher the down payment, the lower the interest rate.

Sometimes borrowers with less-than-stellar credit can only qualify for a mortgage if they have a larger down payment.

Some types of mortgages do not require a down payment, including VA or USDA loans. A VA loan is only available to current and former service members. USDA loans are given to borrowers who are buying a home within the USDA guidelines, which usually means in a rural or less-populated area.

Two other popular loan types are FHA mortgages and conventional loans. FHA loans are popular with first-time homebuyers because they have lower down payment requirements and credit score minimums. Conventional loans are some of the most popular mortgages because they have fewer fees than FHA loans, but can have slightly higher down payment minimums.

Home Equity Loans: 

A home equity loan is a loan that uses your existing home’s value as collateral. You can borrow up to a certain amount of the existing equity in your home. Your equity is defined as your home’s current market resale value minus the remaining mortgage balance.

You can take out a home equity loan even if you still have a mortgage on the loan. In this case, it may be referred to as a second mortgage.

Interest rates on home equity loans are often higher than on primary mortgages because the lender believes borrowers will prioritize their first mortgage. Terms for home equity loans range from five to 30 years. Some home equity loans may charge a prepayment penalty if you repay the balance ahead of schedule, but this depends on the lender.

Borrowers often take out home equity loans to pay for home repairs or remodeling projects. However, you can also use a home equity loan to pay off other loans, cover a child’s college tuition or even buy another home.

Student Loans

A student loan is a type of installment loan. Like personal loans, student loans are also unsecured. If you default, no one can take your degree away, right?

There are two main types of student loans: federal and private. Federal student loans are guaranteed by the federal government, while private loans are provided by third-party lenders.

Repayment terms for federal student loans generally range from 10 to 25 years, depending on the repayment plan. Unlike other types of installment loans, you can change the repayment terms of a federal student loan without refinancing.

Federal student loans have fixed interest rates, while private student loans can have fixed or variable interest rates. Private student loans often have repayment terms between five and 20 years, but this varies depending on the exact lender and the type of loan.

Student loans can be used for almost any education level, ranging from community college to a PhD program. Except in rare cases, student loans require that you attend an accredited school to qualify.

Student loans can be used to pay for several different expenses, including:

• Tuition
• Books and supplies
• On-campus room and board
• Off-campus housing
• Computers and software

Also, you may have to take a certain number of credit hours to maintain eligibility for a student loan.

Here are the most common benefits of installment loans over other types of credit:

Fixed Interest Rates

When you take out a loan, you will either have a fixed or a variable interest rate. Variable interest rates may change during the loan term, sometimes as often as once a month.

Many installment loans have fixed interest rates, which means that the rate will stay the same during the loan term. This also means that the monthly payment won’t change, no matter what happens with external interest rates or economic factors. 

If you can lock in a low or reasonable interest rate, you will be protected if rates increase later on. And if rates drop even further, you can try to refinance your installment loan to get a lower rate. However, you do need to have good credit and a stable source of income to qualify for refinancing.  

Predictable Monthly Payments

When you have an installment loan with a fixed interest rate, your monthly payments will stay the same every month. This makes budgeting easier because you know exactly how much you have to pay each month. 

If you have a revolving line of credit, like a credit card, your payments can vary depending on your balance and the interest rate. This can result in much higher monthly payments if interest rates increase. 

Flexible Repayment Terms

Installment loan terms can vary widely, depending on the loan product. If you want to manage your cash flow, you can choose a loan with a long repayment term and lower monthly payment. But if you’d rather pay off the loan ASAP, then you can opt for a shorter term and a higher monthly payment.

Some borrowers opt for longer terms, even if they can afford a higher payment. Many loans let you pay extra every month and pay off your loans early, but some will charge a prepayment penalty. Understand your loan term before paying it off ahead of schedule. 

Can Help You Build Credit

Whether you have no credit, bad credit, or good credit, taking out an installment loan can help boost your credit score.

When you have an installment loan, the lender will typically report your payments to all three credit bureaus: Equifax, Experian, and TransUnion. These are the three companies responsible for compiling your credit reports.

If you make payments on time, then you will build a positive payment history. This typically makes up 35% of your credit score.

Having an installment loan with a good payment history can help you qualify for more loans or lower interest rates. If you maintain financial discipline with your installment loan, you will reap the rewards for years to come.

Even if you think you’re taking out an installment loan for a good reason, you should keep some aspects in mind before you sign a lender’s contract. 

High Interest Rates and Fees

Installment loans can have high interest rates and fees, especially if you have a low credit score or no credit history. These interest charges can add up quickly and ensure that you’ll pay much more than you initially borrowed. 

When taking out a loan, you should also understand the APR, not just the interest rate. The APR will include all mandatory fees, so it’s a true reflection of how much you’ll pay, while the interest rate figure will not include the fees. And if you have subprime credit, you may have to pay more fees than if you have good or excellent credit.

Debt Accumulation

There’s one thing you should understand if you want to take out an installment loan: the lender is not your friend. Lenders do not care if you can afford your loan payment while trying to attain other goals such as saving for retirement or buying a home.

It’s entirely possible to take out an installment loan and then struggle to pay your bills, especially if you lose your job or experience a medical emergency. Managing multiple loans is also stressful. If you don’t sign up for automatic payments, you can accidentally miss a payment, which can result in late fees and impact your credit.

Credit Score Impact

An installment loan can be good for your credit. It can help you establish a positive payment history which can boost your credit score, especially if you’ve never taken out a loan before.

But the reverse is also true. Missing a payment could cause a significant decrease in your credit score. Also, the more loans you have, the higher your debt-to-income ratio. This can make it harder to qualify for loans in the future.

Also, don’t borrow more than you can afford to pay back if something goes wrong. Many borrowers discover this when they lose their jobs, run out of savings, and can no longer afford to make payments on their installment loans. Defaulting on a loan can cause your score to plummet and can take years to recover from.

Accessibility for Subprime Borrowers

If you have subprime credit, you’ll have a much harder time qualifying for installment loans. Many types of installment loans, including mortgages, have strict credit score requirements. 

When you’re a subprime borrower, you have to be careful when taking out an installment loan. Make sure to understand interest rates and fees and try to refinance the loan when your credit score improves. You can also add a cosigner, which can help you get a better interest rate.

Installment loans can have benefits and drawbacks, depending on your circumstances and level of financial discipline. Other credit products may be more suitable for you, but they also come with risks. Here are some other types of financing to consider.

Credit Cards

A credit card is often much easier to qualify for than an installment loan. Issuers offer credit card products for all types of borrowers, even those with poor credit.

However, credit cards can vary widely. Some cards have low APRs and a slew of perks, while others have high APRs and few benefits. But using a credit card successfully can help you build your credit so you can qualify for a better card — or installment loan — later on.

Some credit cards offer a pre-approval process, through which you can see if you are likely to qualify without hurting your credit score. But you can also do research and find credit cards that fit your credit score profile. 

Payday Loans and Short-Term Alternatives

Payday loans and title loans are the easiest types of loans to get. But they’re also the most expensive — and they can be financially risky. These loans often charge 400% APR or higher, which means you can pay hundreds of dollars in interest even for a small loan. 

These loans often have confusing terms that can make paying off the loan difficult. You should do whatever you can to avoid these loans, whether that means borrowing from family or friends, selling items you own, or starting a side hustle. 

Picking the best installment loan isn’t impossible, but it can feel that way if you don’t know where to start. Here’s what to know about choosing the right loan for you:

Consider Important Factors

One of the biggest things you need to consider when taking out an installment loan is the interest rate. You should always scrutinize the APR, not just the regular interest rate. 

When comparing APRs, make sure to compare the same repayment term. Use a loan comparison calculator to see how much you’ll pay over the life of the loan. This will help pick the best loan with the lowest total interest charges and fees.

You should also compare lenders based on their customer service record. You can find reviews on sites like Trustpilot, Reddit, and the Better Business Bureau. If a lender has poor reviews and negative comments, it may be best to avoid it.

Research and Compare Options

The first step is to determine what kind of loan you need. For example, if you want to buy a car, an auto loan will be your best option. But if you want to pay off existing credit card debt, you may want to consider a personal loan or home equity loan.

It’s best to review your options carefully, because choosing the wrong kind of loan could cost you hundreds or even thousands in extra interest paid. If you’re not sure what the best lending option is, you can also consult with a financial professional. 

Understand the Application Process

When you apply for a loan, you will often be required to provide the following documents:

• Driver’s license or other form of official identification
• Tax returns
• Bank statements 
• Pay stubs

If you are applying with a cosigner, you need to provide their information as well. 

Often, you won’t know exactly what kind of interest rate you’re eligible for until you apply for the loan. But in some cases, you can see your interest rate before you submit a full application. This is part of the pre-approval process.

Make sure you read through the lending agreement in full. If you have any questions, contact the lender and ask them to clarify. Some lenders may switch up the terms when you apply so you want to ensure there’s no bait-and-switch.

Once the loan is approved, you will finalize everything and prepare to receive the funds. This will vary depending on the type of loan you have. 

For example, if you have a mortgage, the funds will be sent to the seller or the seller’s mortgage company. If you’re taking out a personal loan, the money will usually be deposited directly into your bank account. 

Have an installment loan already? Here’s what you should understand to manage it successfully.

Repayment Strategies

First, you should figure out what you want to pay toward the loan. For most people, the minimum payment is the most they can afford while taking their other bills and savings goals into account.

However, if you can afford to pay extra on your installment loan, you can save hundreds, thousands, or more in total interest. But just know that some installment loans come with a prepayment penalty, which will be assessed if you pay off the loan before the repayment term.

Look through the loan agreement before you sign. That should state if there are any prepayment penalties. Sometimes you can even be assessed for a prepayment if you refinance your installment loan with a new lender.

If you end up having financial problems, such as losing your job or having a medical emergency, you should contact your lenders immediately. Ask if they have any deferment options, where you can postpone payments temporarily until your situation improves.

If the lender has a deferment program, you may have to pay a small fee to access it. However, it’s better than missing a payment and owing a late fee.

Avoid Common Pitfalls

One of the biggest mistakes you can make with an installment loan is to pay your bills late. Even just a single late payment can drop your credit score 100 points. The later your pay, the worse the hit to your credit score.  A 30-day late payment is better than a 60-day late payment.

You can avoid late payments by setting up automatic payments on your account. Autopay will take your monthly payments and withdraw the amount from your bank account. 

Remember, your installment loans are not usually set in stone. You can almost always refinance your loan to get a lower interest rate. There is no limit to how often you can refinance a loan. Some borrowers may refinance a loan annually if they qualify for a lower interest rate.

And if you need a break in your finances, you could get a lower monthly payment by refinancing to a longer term. Remember, this will usually result in you paying more interest over the life of the loan. However, if it makes your life less stressful, it may be worth it.

Have a Long-Term Financial Plan

If you already have an installment loan, you should understand what the term and rate is. If possible, see if you can refinance to a lower interest rate. That could help pay less in interest over time. Use this experience as an opportunity to learn more about your loans.

If you have bad credit, an installment loan can be like training wheels — by making payments on time you can improve your score so you can have more options available the next time you need to borrow money. Handling your loans responsibly will improve your credit score and can help you qualify for lower interest rates later on. 

Consumers have some protections from predatory lenders. Here’s what you should understand before you take out an installment loan:

Laws That Safeguard Consumers

Before taking out a loan, you should understand the interest rate, repayment term, applicable fees and more. The lender should provide this information to you. If you sign up for the loan and the terms, rates and fees are different, then you may have a reason to file a complaint in accordance with the Truth in Lending Act (TILA). 

The TILA is the law that states that lenders must disclose pertinent information about the loan beforehand. If the information is not correct, there are several steps you can take.

If you have issues with a lender, you can report them to the following agencies:

• Consumer Financial Protection Bureau (CFPB) 
• Your state’s consumer protection office
• Federal Trade Commission (FTC)

You can also try to contact your local representatives because they may offer more assistance. 

A Patchwork of State Regulations

There is no federal cap on interest rates for general consumers, but some states have their own limits. Most states have a limit on the interest rate you can have for a loan, usually 36%. But some states have no limits, which can result in high-interest loans like payday loans and title loans.

The main federal law around interest rates only pertains to the military. For example, if you’re a service member, you will be protected under the Servicemembers Civil Relief Act (SCRA). This ensures that service members don’t have to pay more than 6% or 36% interest, depending on your status.

If you plan to buy a house, car, or finance your education, you’ll probably encounter some type of installment loan. Knowing how installment loans work can help you save on interest and select the best type for your specific financial situation.

Lenders often use confusing language when trying to sell you on a particular loan. If you can understand loan terminology, you can ignore the sales pitch and bullet points and read the fine print to make the right decision.