Understanding How Installment Loans Work

What Is an Installment Loan? Types, How They Work

When you want to cover unexpected costs, consolidate your debt, or even want to pay for those big tickets like vacations or weddings, you generally opt for a loan. To fulfil our different purposes, we are offered the flexibility to choose the one that fits our needs, but these are the subsets of the most common loan called installment loans. This is what we have covered about installment loans, types, and a few examples to help you better understand how you can manage your financial needs with them.

Key Highlights

  • In installment loans, the lender gives you a lump sum of your loan that you pay off in monthly installments for a set period.
  • Along with the borrowed money, you pay interest and other charges associated with the loan, like origination fees and prepayment penalties if the loan is prepaid.
  • Installment loans include auto loans, personal loans, mortgages, student loans, etc, and their eligibility requirement varies depending on the type of loan and the lender. 

What is an installment loan? 

installment loans mean making regular payments against your borrowed loans that are not confined to personal loans but to commercial ones. The regular payments include the principal amount and the interest on the loan. Here, the installment you made against the borrowed loan depends on various factors like interest, loan terms, etc. However, these installment loans often come with fixed payments, which means you have to pay a fixed amount over the long term. Some common examples of installment loans are mortgage loans, auto loans, personal loans, etc. The exception to fixed installment rates is mortgage loans that have variable rate loans. 

What are examples of installment loans? 

Some of the common examples of installment loans are 

1. Personal Loans

Personal loans are legitimate installment loans used for medical expenses or renovation. These are offered by banks, credit unions, and online lenders, and they come with fixed interest rates, and you pay fixed monthly installments. Personal loans are mostly unsecured, which means you don't need collateral, and this is why they come with higher interest rates than other secured options like mortgages or auto loans.  

Here, you must understand that all lenders offer personal loans to meet every expense possible, from weddings to vacations. Still, only some lenders or financial institutions will provide a loan for the same purpose. Some restrict what funds can be used; therefore, you must ensure your needs are fulfilled before you go for it. 

2. Auto Loans

When you want to purchase a new car or any other vehicle and want to go for a loan to finance it, the loan you get is called an auto loan. You can get auto loans through credit unions, banks, and online lenders while getting in-house financing for your car. The major benefit of auto loans is that they offer lower interest rates and more repayment flexibility.

Unlike personal loans, auto loans are secured loans, meaning you must keep collateral against your big purchase. If you default on your loan, the bank has the legal authority to seize your vehicle. 

3. Student Loans

When you want to finance your college education or related expenses like books, supplies, housing, and food, you go for student loans. The Federal government and online lenders offer these. Federal student loans are available to every borrower eligible to attend a US college or university. They all have the same interest rates. Federal loans have more benefits than private lenders; therefore, turning to federal loans for student loans is good.

4. Mortgages

A mortgage is a type of loan that you take out to purchase a house. It comes with a maturity of 15 years to 30 years, where you pay monthly repayments until the loan is fully repaid. They come with fixed interest rates; however, other mortgages come with adjustable rates. In adjustable-rate mortgages, the interest rate fluctuates according to the market rates.

How does an Installment Loan work? 

In installment loans, you borrow an amount from banks, credit unions, or online lenders, which they provide in a lump sum, and you pay it over a set period ranging from 1 year to 30 years. Most installment loans come with fixed interest rates and regular monthly payments, which you pay a portion of each month over the life of the loan. Installment loans generally work depending on the type of loan and lender; however, there are general characteristics.

  1. Principal: You borrow a fixed amount from the lender, which they disperse after approval. You can't change the principal amount after you agree to the loan terms.  
  2. Term: Repayment terms mean the time you will need to repay the loan, which can range from one year up to decades, depending on the type of loan you choose. Long-term can't be changed, but only some lenders can modify their terms for struggling borrowers. Some borrowers even refinance their debt with different loan terms.
  3. Interest: Interest is the cost you pay for the money you borrow. Each time you make a monthly payment, you pay a portion of interest and the remaining from your principal balance. If you have a fixed interest rate, you have fixed monthly payments, and vice versa.
  4. Fees: Some installment loans come with fees that increase the cost of your borrowing. You pay for upfront origination fees to cover the cost of originating the loan and prepayment penalties if you pay off your loan early.

What is the easiest installment loan to get approved for? 

If we look at the two major installment loan examples, they are collateralized or noncollateralized installment loans. This means lenders require you to pledge your assets against the loan amount you borrow; hence, they are called collateralized loans. Auto loans are the best examples of secured loans. Similarly, you keep your asset as collateral for a mortgage loan, and the borrower only fully owns the house once the loan is fully paid. 

Unsecured or non-collateralized loans require you to provide collateral for the loan. Here, the lender provides loans based on the borrower's creditworthiness and the ability to repay the loan. Lenders usually charge higher interest rates for non-collateralized loans than collateralized ones. Also, it is not easy to secure approval as the lender puts themselves at risk for not securing the loan against collateral. 

Are installment loans worth it? 

Need to know whether installment loans are worth it or not, let's discuss their advantages. 

  1. They have stable monthly payments: In installment loans, you pay the same amount over the loan's life, making it easier if you have a tight budget and other ongoing expenses. Most people want to have stable monthly payments as they are part of their monthly budget, which helps them have a clear view of their other expenses.
  2. They help you to boost your credit score: Having a clean payment history and no remark of due payments or installments can help you increase your credit score. Unlike revolving debt, installment loans can help you reduce your credit utilization, which eventually helps you increase your credit score.
  3. They have a predictable payoff date: You have the flexibility to choose how long you need to pay off your installment loan; therefore, you can select the loan terms according to your condition. The major advantage of an installment loan is you can't reuse that credit like a credit card, which helps you avoid overspending. 

What are the disadvantages of installment? 

  1. They restrict borrowings: In installment loans, you get the funds in lump sums, and you can't increase the amount you borrowed if you need more in case of an emergency or financial hurdle. You don't get the option of minimum payment, which puts you at higher risk if you miss any payment or your income suddenly drops.

  2. You put your assets at risk: Most installment loans are secured loans where you put your assets or as collateral. Banks are authorized to seize your assets in case of default. The major drawback is that if you default on your student loan, your credit increases, making it easier to get a mortgage.
  3. It has a difficult approval process: If you go for secured loans, getting approval for instalment loans may take some time compared to revolving loans. More documentation and eligibility requirements are needed, which may take some time. 
  4. Higher potential fees and closing cost: installment loans are a good option when you require a huge amount to make a big purchase, and therefore, as they are associated with larger borrowings, they come with higher closing costs than other types of credit. 

Final words

If you want to cover your large expenses or unexpected financial emergency, if you want to consolidate your high-interest debt, or if you want to purchase a house or a car, you get a convenient option of installment loans. As each installment loan is specifically designed to fulfil different needs, it is important to understand how they work and how you can get the best out of them. 

FAQs

Where can you get an installment loan?

Installment loans are offered at various financial institutions like traditional banks, credit unions, and online institutions.

Do installment loans impact your credit score?

installment loans can impact your credit score negatively. If you have late payments or hard inquiries, check your credit score. Late payments have a major impact on your credit score and credit inquiry; therefore, it is important to keep your payments regular. 

What are the common types of installment loans?

The common types of installment loans such as personal loans, mortgage loans, auto loans, and student loans.

Read Also:

  1. What is Piggyback Loan?

  2. Home Equity Loans

  3. Bridge Loan

  4. No Credit Check Loan

  5. Construction Loan

  6. Pay Off Loan Early

07 Mar, 2024

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