What are Installment Loans?

Highlights:

• When you take out an installment loan, your lender gives you a lump sum, which you'll repay over time in a series of regular payments called installments.
• There are many types of installment loans. Some, like mortgages and student loans, are available for a designated purpose, while others can be used for any expense.
• Like any other type of credit, installment loans can help you achieve your financial goals, but they can also lead to more debt and financial struggles if not handled responsibly.

Installment loans are a common form of credit used by borrowers to pay for some of their most important — and expensive — purchases. From mortgages to auto loans, installment loans likely already play a role in your everyday life. How much do you really know about them?

How do installment loans work?

When you take out an installment loan, your lender gives you a lump sum, which you'll repay over time in a series of regular payments called installments. These payments include both the principal (the amount you borrowed) and interest charges. Once the loan is paid off, the account is typically closed.

Many installment loans have a fixed interest rate, although some have a variable interest rate that is adjusted according to market conditions. These rates are generally determined by various factors including the stock market, the type of installment loan and the borrower's credit scores. Many installment loans are also subject to various origination, documentation and late fees.

Installment loans can be secured or unsecured. Secured installment loans require collateral — a valuable asset such as a home or a car — to help protect the lender against loss in the event you can't repay what you owe. Secured installment loans are generally less risky for lenders and typically have lower interest rates than unsecured installment loans, which do not require collateral.

What are the types of installment loans?

There are many different types of installment loans. Some have a designated purpose, like mortgages and student loans, while others may be used for any expense. Here's a breakdown of the most common forms of installment loans.

• Mortgages. A mortgage is used to purchase or refinance a home or other property. These installment loans are secured using the property as collateral. This means your lender may initiate foreclosure and seize your property if you default on your loan. Mortgages come with either a fixed or a variable interest rate, and they are typically repaid over a period of 15 or 30 years.
• Student loans. These loans are used to pay for a student's post-secondary education. They may cover the cost of tuition, room and board, books and supplies, and more. Student loans are offered by both federal and private lenders. However, federal student loans typically have lower interest rates, more flexible terms and income-based repayment plans.
• Auto loans. Auto loans are secured loans, usually with a fixed interest rate, used to purchase a new or previously owned car. Because your vehicle is used as collateral, it may be repossessed by a lender if you fall behind on payments.
• Personal loans. These loans can be used for nearly any purpose, from debt consolidation to home renovations and more. Personal loans are typically unsecured, and most have fixed interest rates. Although they tend to be more expensive than mortgages and other secured loans, they may be a good alternative to high-interest credit cards for some borrowers.
• Buy now, pay later (BNPL) loans. BNPL loans are typically offered through online retailers at checkout. These loans allow borrowers to make purchases and repay their debt in a series of equal payments. BNPL loans generally don't include interest charges, but they often feature significant late payment penalties.

Pros and cons of installment loans

Like any other type of credit, installment loans can help you achieve your financial goals, but they can also lead to more debt and financial struggles if not handled responsibly. Here's what you'll need to consider before taking out an installment loan.

Pros

• Fixed interest rates. Although installment loans generally have fixed interest rates, the rate you're offered will vary based on your credit scores and whether the loan is secured with collateral. In general, the fixed interest rate with installment loans is usually less than credit cards and other revolving credit accounts.
• Predictable repayment schedule. Because your repayment schedule and the payments themselves are predetermined, it may be easier to accommodate your loan payments in your household budget, making it less likely that you'll default on the loan.
• Large principals. The amount of an installment loan, or the principal, can be quite large. That's why they're often used to finance the most expensive consumer purchases. Credit cards and other kinds of revolving credit are typically restricted by more modest credit limits.

Cons

• Lengthy repayment schedule. You'll pay off your installment loan over a period of months or even years. If your finances change drastically during this time, your original principal and interest payments may become too expensive for you to afford. Similarly, if the economy shifts downward, your fixed interest rate may suddenly be above the market rate. In these cases, borrowers may consider refinancing their loan to secure a lower interest rate.
• Closed-end credit. After you've paid off your installment loan, your account is terminated, meaning you can't access additional financing without submitting a new loan application. Compare this to a credit card or other types of revolving credit accounts, which usually remain open — even if you have a zero balance — until you opt to close the account.

If you're considering an installment loan, also remember the impact a new loan may have on your credit scores. Payment history typically accounts for the largest portion of your credit scores. So, making payments on time over the life of the loan may help increase your credit scores. Installment loans can also lengthen your credit history and diversify your credit mix, which can have a favorable impact on your credit scores.

However, on the flip side, missing even a single loan payment can cause your credit scores to drop. Installment loans also add to your overall debt. Too much debt can decrease your credit scores and hinder your ability to obtain new credit in the future.

Be sure to carefully consider your financial situation and review your credit reports and credit scores before applying for a new installment loan.