This is how installment loans work

Installment loans are behind some of the most important milestones in life, from buying your first home to financing a car. They make big purchases possible by dividing them into many small payments or installments over terms of six months to 30 years.

However, not all major purchases are suitable for installment loans. As with any type of debt, it is important to consider all of the pros, cons, and costs of applying for and paying back an installment loan.

What is an installment loan?

An installment loan is a form of financing that is repaid in almost equal steps over a certain 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 reach hundreds of thousands of dollars to be paid over decades.

The two main advantages of an installment loan over credit cards or other lines of credit lie in their structure. Installment loans have a set “term” or a period of time in which you must pay off your debts. They also have a fixed interest rate that doesn’t change even if the base rate rises or falls as the economy fluctuates. With those two items locked down, you will know how much you are paying each 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 is funded, you cannot withdraw any more money without applying for a new loan. You will be paid a lump sum.

Therefore, an installment loan is best used “for a specific purpose, because once you have those funds, ideally you want to use (them),” said Akbar Rizvi, chief loan officer at Spring Bank.

The simplicity of the repayment is also attractive: “You make your payment, it gradually decreases every month, and when the term is over you are done,” says Rizvi.

Types of installment loans

Installment loans are most commonly used to finance all or part of a purchase when you have a down payment.

The three most common types of installment loans are mortgage loans, auto loans, and personal loans. Each requires 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 borrowing amount.

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

Home mortgages

Home loans, commonly known as mortgages, cover the price of a building that is intended for living. Mortgages can be used to purchase single-family houses, condominiums, and many other forms of housing. Since these are secured loans backed by the property they are used for, the lender can repossess that property if the borrower defaults on the loan.

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

Car loans

An auto installment loan is used to finance a new or used car. It usually runs for between 24 and 84 months.

“When you have a 60 month auto loan, you pay monthly installments or payments for 60 months each month and pay that balance of what you borrowed back to zero at the end of the loan,” said David Tuyo, president of the university Credit Union in Los Angeles.

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

A down payment isn’t always required, but a down payment will reduce your monthly payments and can help you get a better interest rate. As with mortgage loans, the vehicle can be repossessed if the borrower fails to repay the loan.

Personal Loans

Personal loans are offered by a variety of institutions and are usually, but not always, unsecured. The terms can be anywhere from six to 60 months, and the loan amount can go up to $ 100,000 for borrowers with excellent credit ratings. Most personal loans, however, are for much smaller amounts.

The interest rate on a personal loan as well as the maximum loan amount are determined by a variety of factors, from the creditworthiness of the borrower to his income to the amount of his other debts.

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

Advantages and disadvantages of installment loans

Installment loans are often the only way to make a major purchase that a buyer likely doesn’t have the cash to upfront. With a fixed interest and payment plan, the borrower knows how much they will take on, how much interest they will pay over the life of the loan, and when the loan will be repaid.

There are many reasons to consider installment loans for a larger purchase, but they can also come with disadvantages. While they provide a way to break a big purchase into manageable payments, the biggest question you should ask yourself is, “Can I afford this loan?”


  • Breaking large purchases into monthly payments

  • Available to people even if they don’t have great credit (albeit with less favorable interest rates)

  • Fixed rate for the life of the loan

  • Clear start and end dates for the repayment of the loan


  • Fees may apply, including registration, creation, and prepayment fees

  • Failure to pay can result in withdrawals and negative credit ratings

  • Lenders may not be flexible with payments in the event of financial distress

Installment loans can also come with numerous fees that need to be considered. These can include an application fee, a commitment fee, or even an early loan repayment fee.

“Rather than just looking at the monthly payment, I urge borrowers to look for hidden fees like application fee, credit report fee, late payment fees, or circumstances where an interest rate could change,” said Carol O’Rourke, chief 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 home or car, penalties can be even harsher if you can’t make the monthly payment. Lenders have the right to repossession of your property in lieu of paying, which will also do significant damage to your creditworthiness. Before applying for a loan, do your homework with the lender and find out what your options are when you are in a financial emergency.

“If an institution has thousands of credit servicing complaints or mismanagement or a bad reputation but has a slightly better interest rate, it may be worth contacting another financial institution to make sure,” Tuyo says.

Alternatives to the installment loan

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

You can apply for a credit card instead. Credit cards that offer an introductory period with an annual interest rate of 0% can be useful for funding large purchases over time. You should make sure that you can pay off the remaining balance before the end of the introductory phase if you go this route. In this case, it is an interest-free loan. But do not keep any credit beyond the introductory phase, or you will pay interest, which can easily exceed 25%.

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

Consumers may also be able to set up a personal line of credit with their lender that they can use when needed. Lines of credit can be unsecured if you have excellent credit, or secured with personal property, such as: B. with a home equity loan or a home equity line of credit (HELOC). With a line of credit, you can withdraw the required amount and pay it back – similar to a credit card, but at significantly lower interest rates, as the loan is protected by ownership.

Is an installment loan right for your purchase?

With large life expenses, an installment loan can offer a lot of flexibility, but before applying for one, it is important to determine what you will need the money for and whether this is the right option for your overall financial picture.

Above all, ask yourself the question of whether you really need what the installment loan is intended for and whether you can then afford the monthly payments.

Tuyo explains it by distinguishing between “wanted” and “unwanted” debt.

“Desirable debts will add to your net personal wealth,” he says, “while undesirable debts are unnecessary debts that don’t add to your net worth. An example would be to buy a couple of credit cards and then use an installment loan to pay for frivolous trips. ”

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