What are installment loans and how do they work?

Personal loans can be a useful financial tool to help cover the costs of unexpected expenses, consolidate debt or even pay for big-ticket items like vacations or weddings. There are many different types of loans available to consumers and among the most common are installment loans, which have their own subset of loan options.

If you have a major upcoming expense and don’t have the cash to pay for it, an installment loan may be a good option. Here’s a look at installment loans, their pros and cons and how to get one.

What is an installment loan?

Installment loans offer the convenience of borrowing a lump sum of money, which can be as little as a few hundred dollars or upwards of hundreds of thousands of dollars.

You can find installment loans through different types of lenders including banks, credit unions, online fintech companies and more. For example, a university can also be a lender of educational installment loans to its students.

Depending on the type of installment loan you select, the use of funds may be restricted to purchasing a particular asset, such as a residential property or a car. Other loans, however, allow funds to be used for open-ended purposes, so long as the money is not used toward anything that’s against federal or state laws.

“Installment loans allow consumers to purchase what they need while managing payments over time based [on] their budget,” says Terry O’Neil, head of connected commerce and strategic growth initiatives for Citi. “Given the various payment terms and loan durations, installment loans can provide consumers the opportunity to pay for larger, one-time purchases like an engagement ring or unexpected purchases like replacing a broken refrigerator.”

How installment loans work

Installment loans can be unsecured or secured. Unsecured loans don’t require collateral to back the loan. Secured loans require an asset of value or other guarantee to hedge the risk of a borrower defaulting on the debt.

In exchange for letting you borrow money upfront, the lender charges interest fees on top of the  original loan amount. You’ll also need to repay the entire balance by a certain time frame, which is called the “loan term”. This time frame might be a year or as long as 30 years. 

Loan interest can be fixed, which means it stays the same from the time you sign the loan agreement throughout your repayment period. Some installment loans have variable rates that change intermittently based on economic fluctuations. 

With a fixed-rate installment loan, you can expect to repay the debt in equal monthly payments throughout your repayment term. Variable rates, however, are harder to anticipate and will have a varying minimum payment during your repayment timeline.

Types of installment loans

There are various types of installment loans available, which are designed for different borrowing purposes and funding levels: 

• Personal loans: Personal loans are used for a variety of reasons, like credit card debt consolidation, unexpected expenses (like hospital bills) or large planned costs, like a wedding. Personal loans are usually unsecured, but some secured personal loan products exist.
• Student loans: These loans are specifically used to pay for higher education costs. They are available from both the federal government and private lenders. Federal student loans generally come with more robust borrower protections and unlike private student loans, the rates aren’t dependent on credit.
• Mortgages: These are secured loans used to purchase residential homes or commercial property. Mortgage loan lenders use the property to secure the debt. They’re usually repaid over 15 to 30 years.
• Auto loans: If you need to buy a car, these loans are designed for just that. Like mortgages, auto loans use the purchased asset as collateral for the loan. If you fail to make your auto loan payments, the lender reserves the right to repossess the vehicle. Repayment terms typically range from two to seven years.

Installment loan pros and cons

Installment loans may not be right for everyone. There are advantages and disadvantages to using this type of financing.

Pros

• Helps you pay for large purchases.
• Might offer fixed monthly payments.
• Helps build your credit mix.

Cons

• Borrowing isn’t open-ended.
• Generally requires good credit.
• Potentially long-term impact on your budget.

Installment loan vs. line of credit: What’s the difference?

Aside from an installment loan, another category of debt is called a line of credit. Installment loans offer a fixed borrowing amount and one lump-sum disbursement of funds. Once the lender provides the funds, you don’t have access to more credit later on through the account. 

A line of credit, on the other hand, is a revolving extension of credit. This type of funding typically imposes a maximum borrowing limit, which can be borrowed against on an ongoing basis. When you hit the borrowing limit, you must make payments to the outstanding debt in order to free up some of the credit line in order to borrow more funds.

How to get an installment loan

Lenders have different requirements for loan applicants. However, if an installment loan sounds like the kind of financing you need, here are the typical steps to get one:

1. Check your credit. Requesting a free copy of your credit report on AnnualCreditReport.com, and checking your score keeps you informed about where you stand as an applicant. With this knowledge, you can better gauge the likelihood of getting approved for a loan. If you don’t have strong credit but need a loan, consider focusing on improving your credit score before applying, if possible.
2. Shop around for the lowest loan rates. Regardless of your credit, always check interest rate offers from a few different lenders. In addition to having their own underwriting requirements, lenders offer a range of different rates. This step typically involves a soft credit check that won’t impact your credit. The lower the interest rate you lock in, the lower your out-of-pocket borrowing costs for the loan will be.
3. Complete a formal application. Once you’ve decided on the lender you want to move forward with, follow its application instructions. Filling out an application provides key information about your financial situation. Lenders use this information to run a hard credit inquiry to determine the risk involved with loaning you money.
4. Submit additional documents. You might be asked to provide additional documents to prove your income or verify other information. To avoid delays in processing your application, be sure to have these documents ready. For example, it’s a good idea to gather your recent pay stubs and government-issued ID.
5. Start making loan payments. If approved, you’ll likely need to make your first installment loan payment one billing cycle after the funds are disbursed to you. Ensure that you make your full monthly payment on time to avoid a hit to your credit.

Should you get an installment loan?

Whether an installment loan is the right option for your current needs depends on your financial situation. Ideally, saving up for a major expense helps you avoid getting into debt and paying extra for the convenience of borrowing the money from a lender.

However, if the purchase is urgent and you’re confident that you have reliable means to repay the loan, installment loans can offer greater flexibility. 

“One advantage of installment loans is that they have a set monthly payment and payoff schedule, so they enable consumers to fit major purchases into their budget with payment allocations that work with their unique lifestyles — all the while knowing that the purchase will be fully paid at the end of the loan terms,” says O’Neil.

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