We’re all familiar with the concept of taking out a loan. You need money, so you borrow it and pay it back with interest over an agreed-upon amount of time. But exactly what is an “installment” loan?
What is an installment loan?
When you apply for an installment loan, you’re asking to borrow a specific amount and agreeing to pay it back, including interest, in equal installments over a fixed period of time. With an installment loan, you agree to pay the same amount each month for the duration of your loan, unlike with a credit card where you get to choose how much you pay at the end of each statement period.
To determine how much you can borrow with an installment loan, a lender will look at your annual income, your credit score, and your debt-to-income ratio. The lending institution may also ask for information about your employment history in the interest of assessing your ability to repay the loan.
Examples of installment loans
Chances are you may already have an installment loan, as they’re quite common and include the following:
Typically auto loans range from 12 to 96 months in terms of length, with the average new car loan lasting approximately 65 months, according to Autotrader. Because these are secured loans, meaning your vehicle serves as collateral (and the bank can seize it if you don’t keep up with the payments), these loans generally offer lower interest rates than credit cards. The national average interest rate for a 60-month auto loan is 4.21%, whereas the average credit card interest rate for new offers is 19.24% — clearly a sizable difference.
Homebuyers take out mortgages to finance property purchases and then make monthly payments comprised of the principal amount plus interest. The amount of the mortgage is the price of the home minus any money the buyer puts as their down payment.
Mortgage loans also typically involve fees, such as an origination fee, the cost of a title search, attorney fees, and other closing costs — just to name a few. In some cases, borrowers may be able to roll these fees into the mortgage. While this saves borrowers from spending more money up front, they will then be paying interest on those fees over the life of the mortgage, making those charges much more costly.
Most mortgages are repaid over a 30-year period. Interest rates may be fixed for the duration of the loan, or they may be adjustable. “A fixed APR (annual percentage rate) loan will have the same interest rate for the entire term of the loan, while a variable APR loan is subject to changes in the market, such as a reduction in the Federal funds and prime rates,” explains Greg Mahnken, credit industry analyst at Credit Card Insider.
Like an auto loan, mortgages are secured by the lender’s ability to take over the property if the borrower fails to keep up with the loan.
If you’re in need of cash, a personal loan allows you to borrow a set amount and pay it back in fixed monthly installments. Because these loans are unsecured — meaning there’s no collateral for the bank to seize — the interest rates tend to be higher, falling anywhere from 5% to 36%, depending on the lender and your creditworthiness. Typically, personal loan amounts range from $1,000 to $50,000 and last between 12 and 60 months.
Aside from those mentioned above, installment loans can also include home equity loans, student loans, and more. So, as you can see, it’s likely you’re already personally familiar with the concept of installment loans.
Important things to consider when applying for an installment loan
Determine the amount you need up front
Unlike when you’re extended a line of credit, when you apply for an installment loan, you’ll need to know how much you’d like to borrow at the outset. With a credit card, you have an overall limit you can spend, but you can choose how much of your credit line you use at any given time. In contrast, your installment loan will be for a fixed amount, and if you find yourself needing more money down the road, you’ll have to apply for another loan.
Interest rates are determined by your creditworthiness
The interest rate offered by the lender will be based on your creditworthiness, so the lower your credit score, the higher your interest rate is likely to be.
“Your credit history is a factor in almost all lending decisions,” says Mahnken. “Your interest rate can be directly affected by your credit history and credit scores. Over the course of a long-term loan, a better interest rate could save you thousands of dollars. In the case of a mortgage, it could save you tens of thousands of dollars.”
Keep an eye out for prepayment penalties
It may seem like paying off your loan early would be a good thing and you may be excited you have the cash to do so, but this isn’t always something your lender will be equally pleased about. Whether you’ve been saving up or had a sudden windfall, before you write that check, make sure you won’t be subject to any prepayment penalties. These penalties allow your lender to recoup some or all of the interest you would have had to shell out if you didn’t pay your loan ahead of schedule.
Chane Steiner, CEO of Crediful, suggests that you carefully review the terms of the installment loan before you ever sign the contract: “Of course, the lender wants to be repaid but they also want the profits resulting from interest. Check the fine print and try to secure a lender who doesn't include prepayment penalties.”
Read the fine print on your origination fees
Installment loans may have an origination fee, which represents the cost to process and administer your loan and is charged by the lender.
“A common place you’ll see an origination fee is in the closing costs of a mortgage,” says Mahnken. “Origination fees are usually no more than 8% of the loan amount, and can be much less if you have strong credit. Some loans offer no origination fees as a selling point.”
Be sure to find out if your loan has an origination fee and if you’re expected to pay it at signing or if it will be rolled into your loan. Sometimes loans with no origination fee might sound good, but they may also come with a higher interest rate. If you have the cash, paying off your origination fee instead of including it in the financing could save you a lot in the long run. Always do the math to make sure you know what you’re paying and which loan is actually the most affordable.
Where can you get an installment loan?
If you’re in the market for an installment loan, check with your local bank or credit union to see what it offers. Installment loans are also available through many online financial institutions. Just be sure you’re dealing with a reputable and legitimate business. Predatory lenders exist and will try to take advantage of borrowers by charging sky-high interest rates and requiring short repayment terms, rendering these loans very difficult to pay back on time.
To determine if you’re dealing with a reputable lender, you can check the Better Business Bureau's website. Because lenders are required to register within the state where they do business, you can also check with your state attorney general’s office.
Is an installment loan right for you?
If you find yourself in need of cash to pay for a purchase, you may have considered simply using your credit card. Or you could borrow against your line of credit by taking a cash advance. But both of these options will likely carry higher interest rates and fees than an installment loan.
Also, with an installment loan, you’re committed to paying the same amount every month. When you use a credit card, you may be tempted to make the minimum payment, which means you’ll be paying off that purchase or cash advance far longer than you would if you were making regular, equal payments. Depending on your spending, your credit card balance and minimum may vary quite a bit, whereas with an installment loan, you can more easily create a reliable budget around what you owe every month.
If you’re considering applying for an installment loan in the near future, it’s a good idea to begin improving your credit score now. The best way to start working on your credit score is to dig into your credit report. You can get your credit reports from each of the three major credit bureaus once per year by going to AnnualCreditReport.com.
Installment loans are a great way to borrow a specific amount of money and make a fixed payment each month to repay it. Depending on your creditworthiness, you may secure an interest rate that’s more affordable than other financing options.