Takeaways
- Installment loans are lump-sum payments, paid back over time with interest.
- Installment payments consist of both principal and interest payments.
- Installment loans have fixed interest rates, allowing for predictable payment plans.
- Installment loan terms depend on your credit score, DTI, and payment history.
- Installment loans finance cars, homes, boats, education, fund home renovations, and more.
Not all purchases need to be made with cash. For most large purchases, you can finance the purchase with a credit product from a bank or credit union. One popular way to get the money you need is to take out an installment loan.
Installment loans give you the cash you need upfront, and you can repay the amount with interest over time. Let’s look at how installment loans work in more detail.
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What Is an Installment Loan?
Installment loans provide you with a lump-sum payment of a principal amount. From there, you repay the principal over time with a set number of payments, typically made monthly.[1]
Each monthly payment consists of several variables. The first is the principal, and the second is interest. The exact proportion of principal to interest with each payment varies over the life of the loan based on the loan amortization table.
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When you first get a loan, your payment consists mostly of interest and a little principal. As you progress in your payments, this changes to a payment consisting mostly of principal. Of course, the exact amount of each payment depends on the specific terms of the installment loan.
For an installment loan, you agree to repay the loan over a set period, called the “loan term.” This term can range from short-term loans paid off in just a few months to longer-term loans that take years to pay off.
Installment loans are used for larger purchases, like buying a new car, purchasing your first home, or making home renovations. You are probably familiar with well-known installment loans, such as auto loans, mortgages, and personal loans.
All installment loans follow a similar structure: the lender provides you the total loan amount upfront, and you pay it back in fixed installments – hence the term “installment loan.” Consumers love installment loans because they provide payment predictability, which allows you to assess affordability.
How an Installment Loan Works
Installment loans offer the most fundamental of loan structures. When you take out an installment loan, you agree to repay the amount you borrow and an additional interest through regularly scheduled payments.
The term of your loan can range from a few months to 1 year, 2 years, or more, depending on the type of loan and the total amount borrowed. Every installment payment is made up of two components: principal and interest. The principal payment decreases the amount you borrowed, and the interest payment is the amount you pay for the privilege of borrowing the money.
Installment loans usually have a fixed interest rate. This means that the interest rate you pay over the life of the loan does not change. For example, if you take out a five-year $100,000 loan with a 5% interest rate, the loan terms will only change once you pay off the loan.
The beauty of fixed interest rates is that they allow you to budget effectively for your monthly payment. Because your payments are consistent, you can predict when and how much you will owe every month. While most installment loans have fixed interest rates, some have variable or adjustable interest rates.
Adjustable-rate loans include personal loans and mortgages, such as the adjustable-rate mortgages (ARMs). If your interest rate is adjustable, your monthly interest payments can fluctuate. Your payments can balloon if the Federal Reserve increases the federal funds rate and interest rates rise. However, your interest payments will decrease if interest rates are lower. Adjustable interest rates add an element of unpredictability to your personal finances.
How to Apply for an Installment Loan
If you need cash to make a large purchase, you must formally apply for an installment loan. Here’s how to get started:
- Review Your Credit: Before officially applying, you need to check your credit score and review your credit report to ensure its accuracy. Many lenders heavily weigh your debt-to-income ratio to determine how much to lend. (Try our plug-and-play debt-to-income calculator.)
- Shop Lenders: Lenders will assess you differently depending on your credit profile. It is essential to shop lenders to see who will give you the best terms – including interest rates and payment terms. Consider online lenders who offer better rates or the best product that fits your needs. For example, you could look at a personal line of credit.
- Check for Prequalification: If you already use a bank or credit union, you might automatically prequalify for a mortgage, auto loan, student loan, or personal loan. Check your bank or credit union’s online portal or talk to a representative about their best options. A smart money move is to ensure all your income and personal information is correct to ensure you qualify for the best products. (Read about how to negotiate a higher salary.)
- Apply For the Loan: You must apply formally once you find the best installment loan. If the loan is approved, you will be given the full (or approved) loan amount, and you can begin making payments according to the agreed-upon payment schedule. (Read about how to apply for a car loan.)
- Avoid Fees: Late or missed payments can lead to late fees and additional penalties, while a more consistent failure to fulfill the loan's payment requirements can lead to credit damage, defaulting on the loan, and even foreclosure (if you have a mortgage).
Read Also: Is an 800 Credit Score High Enough?
5 Types of Installment Loans
Installment loans come in all shapes and sizes. They help finance purchases from cars to education. Here are five standard installment loans:
1. Mortgages
Most homes are financed by new homebuyers with a mortgage, which is an example of a long-term installment loan. The amount of mortgage borrowers take out is the difference between the home's purchase price and the amount of their down payments.
The most common terms for a mortgage are 15 to 30 years and tend to come with a fixed interest rate. Mortgages are secured by the house as collateral.
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2. Personal Loans
One of the most flexible types of installment loans is a personal loan. These loans can be used for a variety of purposes such as renovating a house or funding a much-needed vacation.
These loans range from $1,000 to over $100,000 and can have fixed or variable interest rates. Personal loans can be secured by collateral or be unsecured.
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3. Auto Loans
Car loans are another everyday form of an installment loan. You can take out an auto loan when you purchase a new car and need to finance the purchase. Most dealerships offer financing options, or you can get one from your bank or credit union.
The typical term for an auto loan ranges from 12 to 72 months or more. You borrow the difference between the purchase price and your down payment for an auto loan. Your car usually acts as collateral for the loan. (Read about how to apply for a car loan.)
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4. Buy Now, Pay Later (BNPL)
A more recent form of financing small purchases online is through buy now, pay later services (BNPL). This financing product, offered on online checkout pages, allows you to purchase the product and pay off the debt in installments. If payments are missed, then you may incur fees or interest.
BNPL services can be used on websites like Amazon, Walmart, or high-end luxury goods. Companies like Affirm and PayPal offer these credit products.
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5. Student Loans
Paying for college or graduate school can be expensive. Tuition, housing, books, and supplies can add up quickly. Student loans are a form of installment loan that allows current and prospective students to take out a loan and pay it back in installments with interest over time.
The federal government can issue student loans, or there are private student loans. Interest rates and terms and conditions vary based on the lender you select.
If you have pesky student loans, read more about how to pay off student loans quickly.
Pros of an Installment Loan
With good credit, lenders make getting an installment loan a relatively smooth process. If you need to borrow money, here are some advantages of an installment loan:
- Predictable payment schedule: One of the most enormous benefits of an installment loan is that you have a very predictable payment schedule. Since most installment loans feature fixed interest rates, you will know exactly what your monthly payment will be for the entire loan duration. This makes budgeting much more manageable.
- Lower Interest Rates: Installment loans also have the potential for lower interest rates compared to revolving credit lines, like credit cards. If you have a strong credit history, lenders can give you much more favorable terms for your loans, making installment loans perfect for affordably borrowing large amounts of money.
- Flexibility of Use: Installment loans can be used to fund anything you want. There are personal loans that can fund your next vacation or auto loans to buy your next new card. This flexibility adds to their widespread adoption.
- Builds Credit: Paying off mortgages, car notes, and student loans all add to your credit history. Building credit is an essential way to boost your FICO or VantageScore, giving you better borrowing terms.
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Cons of an Installment Loan
Even though installment loans have several advantages, there are also potential downsides to consider before borrowing.
- Fixed Payment Schedule: Installment loans have a fixed payment schedule. Once your loan terms are set, you must make the payments as agreed. Unexpected financial turbulence that causes late or missed payments often leads to late fees, higher interest charges for future borrowing, and lasting credit damage.
- Long Terms: Longer-term installment loans can be upwards of 30 years. Mortgages or loans with lengthy repayment terms can be high-commitment loans. You need to ensure your budget can handle this type of debt commitment because there is an opportunity cost to making debt payments: you won't be investing in stocks, bonds, crypto, or other asset classes.
- Potential for Variable Payments: If your installment loan has a variable rate, your monthly payments might increase substantially over time. Constantly moving monthly payments can make it incredibly hard to maintain a consistent budget. Steady payments are better for debt management.
- Default Damage Credit: Late or missed payments on an installment loan will be submitted to the credit bureaus. These payment mishaps can stay on your credit report for up to 7 years. That is why ensuring you can comfortably afford any installment loan is essential. Payment mismanagement can tremendously damage your credit score.
Smart Summary
Installment loans are lump-sum payments made to borrowers who apply for the loan. You will receive this payment in cash, which becomes your principal. Installment loans are paid back over time with interest. Your credit score determines the type of loans you are eligible for and the financing terms. Borrowers with high credit scores and clean credit reports tend to get more favorable loans.
Frequently Asked Questions
Debt repayment depends on your personal finances and money habits. Paying off your mortgage, student loans, or personal loan quickly is managing your debt loan. Installment loans can be easy to manage if you don’t overborrow.
No, the interest rate that lenders charge is based on your credit score, type of loan, length of loan, and other factors like your DTI ratio. Applicants with better credit histories will secure better and cheaper loans.
Yes, debt consolidation allows you to convert multiple credit products into one. This will enable you to pay off higher-interest debts like credit cards with a single loan at a lower interest rate, which reduces the total amount you pay over time and helps with payment management.
(1) Consumer Financial Protection. What is a Personal Installment Loan? Last Accessed January 13, 2025.
