How installment loans work

An “installment loan” is a broad and general term that refers to the vast majority of personal and business loans given to borrowers. Installment loans include any loan that is repaid with installments or regular installments.

If you are considering applying for an installment loan, you should first consider the pros and cons. Here’s what you need to know before picking one up.

Key points to remember

  • Installment loans are personal or business loans that borrowers must repay in installments or regular installments.
  • For each installment payment, the borrower repays part of the capital borrowed and also pays interest on the loan.
  • Examples of installment loans include auto loans, mortgages, personal loans, and student loans.
  • The benefits of installment loans include flexible terms and lower interest rates.
  • The disadvantages of installment loans include the risk of default and loss of collateral.

What is an installment loan?

An installment loan provides the borrower with a fixed amount of money to be repaid in regular installments. Each payment on an installment debt includes the repayment of a portion of the principal amount borrowed as well as the payment of interest on the debt.

The main variables that determine the amount of each regular loan payment include the amount of the loan, the interest rate charged to the borrower, and the length or term of the loan. The regular payment amount, usually due monthly, remains the same for the life of the loan, allowing the borrower to easily budget in advance to make the required payments.

Borrowers typically have to pay other fees in addition to interest charges, such as application processing fees, loan origination fees, and potential additional fees such as late payment fees.

Types of installment loans

Common types of installment loans are auto loans, mortgages, personal loans, and student loans. Apart from mortgages, which are sometimes variable rate loans where the interest rate changes over the life of the loan, almost all installment loans are fixed rate loans, which means that the interest rate charged on the term of the loan is fixed at that time. of borrowing.

Secured or unsecured installment loans

Installment loans can be secured (secured) or unsecured (unsecured). Mortgage loans are secured by the home that the loan is used to purchase, and the collateral for a car loan is the vehicle purchased with the loan.

Some installment loans (often called personal loans) are granted without collateral. Loans with no collateral requirement are granted based on the borrower’s creditworthiness, usually demonstrated by a credit score, and repayment capacity indicated by the borrower’s income and assets.

The interest rate charged on an unsecured loan is generally higher than the rate that would be charged on a comparable secured loan, reflecting the higher risk of non-repayment that the creditor accepts.

If you are considering taking out an installment loan, you may want to consult a personal loan calculator first to determine what kind of interest rate you can afford.

Apply for an installment loan

A borrower applies for an installment loan by filing an application with a lender, usually specifying the purpose of the loan, such as buying a car. The lender discusses various options with the borrower regarding issues such as down payment, loan term, payment schedule, and payment amounts.

If an individual wants to borrow $10,000 to finance the purchase of a car, for example, the lender informs the borrower that paying a higher down payment could earn him a higher interest rate. low, or that the borrower could obtain lower monthly payments by taking out a longer-term loan. The lender also reviews the creditworthiness of the borrower to determine the amount of credit and the loan terms the lender is willing to offer.

The borrower usually withdraws the loan by making the required payments. Borrowers can usually save on interest charges by repaying the loan before the end of the term set in the loan agreement.

Some loans impose prepayment penalties if a borrower prepays their loan.

Advantages and disadvantages

Installment loans are flexible and can easily be tailored to the borrower’s specific needs in terms of loan amount and term that best suits the borrower’s repayment capacity. These loans allow the borrower to obtain financing at a significantly lower interest rate than is usually available with revolving credit financing, such as credit cards. This way, the borrower can keep more money on hand to use for other purposes, rather than making a big down payment.

Advantages
  • Ability to finance large purchases

  • The payment amount generally remains the same for the duration of the loan

  • It is usually possible to save on interest charges by paying off the loan sooner

For longer term loans, the downside is that the borrower can make payments on a fixed interest loan at a higher interest rate than the prevailing market rate. The borrower may be able to refinance the loan at the lower prevailing interest rate.

The other main disadvantage of an installment loan is that the borrower is locked into a long-term financial obligation. At some point, circumstances may render the borrower unable to meet scheduled payments, risking default and possible forfeiture of any collateral used to secure the loan.

Installment loans and credit scores

Paying off an installment loan on time is a great way to build your credit. Payment history is the most important factor that contributes to your credit score, and a long history of responsible credit use is good for your credit rating.

As mentioned earlier, your credit score can suffer if you fail to make timely payments or fail to repay the loan, which is also a red flag in the eyes of lenders.

The essential

An installment loan can help you finance a major purchase, such as a car or a house. Like any loan, there are pros and cons to consider. The advantages include flexible terms and lower interest rates, while a major disadvantage is the risk of default.

If you decide to take out an installment loan, be sure to shop around and compare the rates and terms offered by lenders before signing on the dotted line.

Thelma J. Longworth