How Installment Loans Work

Installment loans are behind some of life’s major milestones, from buying your first house to financing a car. They make large purchases possible by breaking them down into many small payments, or installments, over terms ranging from six months to 30 years.

However, not all large purchases are a good fit for installment loans. As with any type of debt, it’s important to consider all of the pros, the cons, and the costs of applying for and paying down an installment loan.

What Is an Installment Loan?

loan installments are forms of financing that is paid down in nearly equal increments over a period of time. It’s a very flexible form of borrowing: while some loans are for relatively small amounts of money over a short period of time, others can go into the hundreds of thousands of dollars, to be paid over decades.

The two key advantages of an installment loan over credit cards or other lines of credit are in their structure. Installment loans have an established “term,” or a period of time you have to pay down your debt. They also have a fixed interest rate, which won’t change even if the prime rate goes up or down as the economy fluctuates. With these two items locked, you will know how much you are paying every month, and how long it will take to pay off the loan.

Installment loans are best for one-time expenses, like consolidating credit card debt or medical bills. Once your loan gets financed, you won’t be able to draw out more cash without applying for a new loan; you will be paid in a lump sum.

That is why an installment loan is best used “for a specific purpose, because once you get those funds, you’ll ideally want to put (them) to work,” says Akbar Rizvi, chief loan officer at Spring Bank.

The simplicity of repayment is also an attractive feature: “You make your payment, every month it goes down little by little, and when the term is over, you’re done,” Rizvi says.

Types of Installment Loans

Installment loans are most often used to finance the total cost of a purchase, or a portion if you have a down payment.

The three most common types of installment loans are home mortgages, auto loans, and personal loans. Each will require you to complete an application with a lender, followed by a review of your credit report and credit score, which will ultimately determine your interest rate and how much are able to borrow.

While personal loans and some auto loans may not require a down payment, a home mortgage usually requires a down payment of at least 3.5% of the purchase price.

Home Mortgages

Home installment loans, commonly known as mortgages, cover the price of a structure intended for dwelling. Mortgages can be used to purchase single-family homes, condominiums, and many other types of housing. Since they are secured loans — backed by the property they are used to purchase — the lender can repossess that property if the borrower defaults on the loan.

The most common types of home installment loans are conventional mortgages, FHA loans, and VA mortgages. Each offers buyers a fixed monthly payment over a period of 15, 20, or 30 years, with a required down payment of between 3.5% and 5%. While conventional and FHA mortgages are available to most buyers, VA mortgages are only offered to current military members and veterans.

Auto Loans

An auto installment loan is used to finance a new or used vehicle. It generally runs between 24 and 84 months.

“If you have a 60-month car loan, you’re making monthly installments, or payments, every month for 60 months, paying down that balance from what you borrowed to zero at the end of the loan,” says David Tuyo, president of University Credit Union in Los Angeles.

Auto loans are offered by a variety of lenders, including retail banks and credit unions. Although many auto dealerships offer financing by working with lenders, you may be able to negotiate a better deal if you shop around and go directly to a lender.

A down payment is not always needed, but having one will reduce your monthly payments and might help you get a better interest rate. As with home mortgages, the vehicle can be repossessed if the borrower stops paying back the loan.

Personal Loans

Personal loans are offered by a variety of institutions, and usually — but not always — are unsecured. The terms can run between six and 60 months, and the amount borrowed can be as much as $100,000 for borrowers with excellent credit. Most personal loans, however, are for much smaller amounts.

The interest rate on a personal loan, as well as the maximum amount borrowed, is determined by a variety of factors, from the borrower’s creditworthiness to their income and the amount of other debt they hold.

These loans are often used to consolidate credit card or medical debt into a lower, fixed interest rate loan payable over a period of time. Personal loans can also be used to finance a major purchase, including home renovations and weddings.

Pros and Cons of Installment Loans

Installment loans are often the only way to make a major purchase for which it’s unlikely that a buyer has the money up front. With a fixed interest rate and payment schedule, the borrower will know how much they are taking on, how much interest they will pay over the life of the loan, and when the loan will be paid off.

While there are a lot of reasons to consider installment loans for a major purchase, they can also have  downsides. While they offer a way to break a big purchase into manageable payments, the biggest question you should ask yourself is: “Can I afford this loan?”

Pros

  • Breaking major purchases into monthly payments
  • Available to people even if they don’t have excellent credit (although with less favorable interest rates)
  • Fixed interest rate for the life of the loan
  • Clear start and end dates to pay down the loan

Cons

  • May come with fees including application, origination and prepayment fees
  • Failure to pay can result in repossession and negative marks on your credit score
  • Lenders may not be flexible on payments in case of a financial emergency

Installment loans can also come with numerous fees that need to be taken into account. These may include an application fee, origination fee, or even a fee for paying off the loan early.

“Rather than just looking at the monthly payment, I urge borrowers to look for hidden fees like an application fee, credit report fee, late fees or circumstances when a rate could change,” says Carol O’Rourke, principal financial coach at SHOR Financial Wellness based in New York. “It’s really important to read the fine print before signing.”

When installment loans are secured by a physical asset, like a house or a car, there may be even more severe penalties if you can’t make the monthly payment. Lenders have the right to repossess your property in lieu of payment, which also causes significant damage to your credit history. Before applying for any loan, be sure to do your homework on the lender, and research what your options are if you have a financial emergency.

“If an institution has thousands of complaints around servicing loans or mismanagement, or a poor reputation, but they have a little better rate, maybe it’s worth going with a different financial institution to make sure you have some peace of mind,” says Tuyo.

Alternatives to Installment Loans

An installment loan isn’t the only tool available to consumers making a big purchase.

You could apply instead for a credit card. Credit cards offering an introductory period with a 0% annual percentage rate can be useful for financing large purchases over time. You’ll want to make sure you are able to pay off the balance before the introductory period expires if you go this route, in which case it is in effect an interest-free loan. But don’t carry a balance past the introductory period, or you will pay interest that can easily soar above 25%.

“If you are disciplined and use it the right way, a credit card can be a great option,” says Rizvi.

Consumers might also be able to establish a personal line of credit with their lender, to draw upon when necessary. Lines of credit can be unsecured, if you have excellent credit, or secured with personal property, such as with a home equity loan or home equity line of credit (HELOC). With a line of credit, you withdraw the amount you need, and pay it back — similarly to a credit card, but at much lower interest, since the credit is secured by property.

Is an Installment Loan Right for Your Purchase?

For major life expenses, an installment loan can offer a lot of flexibility, but before applying for one it’s important to determine what you need the money for, and if it is the right option for your overall financial picture.

Most of all, ask yourself whether you really need whatever the installment loan is intended for, and after that, whether you can afford the monthly payments.

Tuyo explains it by differentiating between “desirable” and “undesirable” debt.

“Desirable debt is going to increase your personal net worth,” he says, “whereas undesirable debt is unnecessary debt that does not increase your net worth. An example would be running up a bunch of credit cards, and then using an installment loan, to pay for frivolous travel.”

But if you intend to use the loan for things like “home improvement projects, that would increase the value of your home, and your net worth” — or for debt consolidation which would save you money — then an installment loan may be your best option.

About Roberto Dias

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