What is an installment loan & how does it work?

Installment loans allow you to borrow money and pay it back in equal monthly payments, usually at a fixed interest rate. They can be handy and versatile personal finance tools. For example, you can use them to make a major purpose or combine credit cards into one loan that you pay off in small, manageable chunks.

One well-known type of installment loan is a personal loan. Other examples of installment loans include student loans, mortgages and auto loans.

What is an installment loan?

An installment loan is a type of closed-end debt. You pay it off over a set number of months or years, also known as your loan term.

Unlike credit cards or lines of credit, which are open-ended, revolving credit, you can’t reuse the installment credit as you pay the balance. If you want to borrow additional money, you must apply for a new loan.

Types of installment loans

You can find several common types of installment loans:

• Personal loans: Personal loans offer funding for nearly any legitimate purpose you need, as long as the expense is not specifically prohibited in the loan contract. Typical expenses that personal loans are used for include debt consolidation, emergency repairs, big ticket purchases and even weddings.
• Mortgages: Mortgage borrowing is used for purchasing a home. These too are installment loans, and the home being purchased serves as collateral for the loan. Mortgages can be obtained from banks, credit unions and online lenders.
• Auto loans: An auto loan is an installment loan that’s designed specifically to fund the purchase of a vehicle. They are available through car dealers, as well as banks, credit unions and online lenders.
• Student loans: Student loans provide funding to cover the costs associated with higher education. These loans can be obtained either from private lenders or from the federal government.
• Payday loans: Payday loans are extremely short term loans meant for emergencies. The interest on these loans is typically exorbitant. This type of lending is typically targeted at borrowers who have bad credit as it offers funding to people who may not qualify for other types of borrowing.
• Buy now, pay later loans: Buy now, pay later loans are typically offered by retailers and are meant to allow you to break up the cost of a purchase into smaller installments. These loans typically do not charge interest or fees.

To find these loans, go through institutions like banks and credit unions, online lenders, mortgage brokers and dealerships. Installment loans may be secured or unsecured.

Secured vs. unsecured installment loans

A secured loan is one that requires a lien against an asset you own such as a home or car. If you can’t repay the loan, then the lender can seize the asset as payment for any balance that remains due. Examples of secured loans include mortgages and auto loans.

An unsecured installment loan, by contrast, does not require an asset to be provided as collateral. The approval process is simpler and usually based on your credit scores, income and debt rather than providing a valuable asset to back up the loan.

Personal loans and buy now, pay later (BNPL) loans are examples of unsecured installment loans. Neither requires collateral. Unsecured personal loans can be funded in as little as the same day you sign and loan amounts are typically under $100,000.

How does an installment loan work?

Installment loans allow you to borrow an approved amount of money, disbursed in a lump sum. They can be repaid over a set period ranging from a few weeks for a product like a payday loan or BNPL plan to 30 years for products like mortgages.

Typically, these loans have a fixed interest rate and require regular payments. The cadence of these payments may be weekly, bi-weekly or monthly.

For monthly installment loans, a portion of each payment goes to the principal amount borrowed and another goes to the interest on the loan. You’ll continue to make the loan payments over the loan term. The lender will close the account once the loan is paid in full, including the principal and interest.

Do installment loans hurt your credit?

Installment loans can harm your credit if you’re late on a payment or when you apply and undergo a hard credit check. Try to choose personal loan lenders that offer prequalification without a credit pull. You will undergo a hard pull when you formally apply, but the score damage should be small and temporary.

A late payment damages your score more than a credit inquiry, so make sure you keep your payment current. To avoid damaging your payment history, consider setting up automatic payments so you don’t miss a due date.

However, certain types of installment loans may have no effect on your credit score. Buy now, pay later financing typically does not require a credit check and payments may not be reported to credit bureaus. As such, they tend not to affect your credit.

Should you get an installment loan?

An installment loan makes sense if you can afford the payment, are financially stable enough to repay it and get some sort of financial benefit from it. Installment loans require a payment commitment that can last as long as 30 years. If you plan to change jobs or anticipate ups and downs in your earnings, an installment loan may not be your best option.

See if an installment loan works for your situation by comparing multiple installment loan lenders. Check out loan comparison sites to see offers side-by-side. If you’re buying a house, you might check with a mortgage broker, who can check different lenders for the best programs.

If you ultimately decide an installment loan is not for you, explore alternatives to installment loans. Your options include personal lines of credit, credit cards and home equity lines of credit.

The bottom line

Installment loans are a convenient option for consumers looking to cover a large expense, unexpected financial emergency, consolidate high-interest debt or buy a car or home.

But before you apply, it’s vital to understand how different types of installment loans work. It’s equally important to shop around with different lenders to find a loan product with favorable terms that works for your financial situation.