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What is an installment loan?
An installment loan, sometimes referred to as a closed-end loan, is a type of loan that allows you to borrow a set amount of money which you then pay back over a set period of time. The payments are called installments, and they’re often paid on a monthly basis.
People usually take out installment loans if they need a lot of extra cash for something specific—like a down payment on a car—or if they have very large expenses, such as hospital bills or repairs to their home or vehicle.
Installment credit is one of the two most common types of credit, along with revolving credit (also known as open-ended loans). Revolving credit is different from installment credit in that it lets you repeatedly withdraw and repay money up to a certain limit.
How do installment loans work?
When you take out an installment loan, your creditor will evaluate your credit score and debt-to-income ratio when deciding how much money to lend you, how long they’ll give you to repay it, and what your interest rate will be. One of the many benefits of having a good credit score is that you’ll get better terms on installment loans.
Once you’re approved for the loan, you’ll usually get the money immediately. 3 Most installment loans have a fixed repayment schedule, which means that you’ll pay the same amount on each installment and finish paying off the loan on a predetermined date that you and your lender agree upon. 4
Loans with longer terms often come with lower monthly payments but higher interest rates. 5 Once the loan is completely paid, the account will be closed permanently.
Common types of installment loans
Most people are familiar with the following types of installment loans:
A mortgage is a type of loan you can use to buy a home.
Mortgages often have a repayment period of 15 or 30 years. 5 Some come with fixed interest rates (interest rates that remain the same throughout the duration of your mortgage), and others with variable (or adjustable) interest rates which can increase or decrease.
Mortgages are a type of secured loan. This means that your lender can take your property—in this case, your house or apartment—if you miss too many payments. In lending terminology, your house serves as “collateral” for the loan.
Auto loans are designed to help you pay for a car or another type of vehicle.
Auto loans generally have repayment periods of one to six years. 7 They’re secured by the car or vehicle you buy.
Car loan interest rates can be fixed or variable. According to Federal Reserve data, the national average interest rate for new car loans was around 5% in August 2021. 8
Student loans are designed to help pay for any form of post-secondary education (e.g., college or graduate school).
Unlike with most installment loans, you typically don’t have to start repaying student loans straight away. With federal student loans, for example, you start making payments six months after you graduate, leave school, or drop below half-time enrollment. 9
Student loans usually feature lower interest rates and more favorable terms than many other unsecured loans do. For example, the average interest rate on federal loans for undergraduates is a relatively low 3.73%. 10 The interest rates for private student loans vary. 11
The downside of student loans is that, unlike other types of debt, they aren’t usually written off if you go bankrupt (unless you can prove that you’re seriously struggling financially). 12
Personal loans are a type of installment loan that can be used for various purposes.
You’ll typically have to pay off a personal loan over a period of 12 to 60 months.
According to Federal Reserve data from May 2021, the national average interest rate for personal loans is 9.58%. 8 Interest rates on personal loans are relatively high because they’re usually unsecured loans, which means they don’t require collateral. You might be able to get lower rates if you can find a cosigner (if your lender allows this).
Debt consolidation loans
Debt consolidation loans are loans that you use to pay off multiple debts with high interest rates so that you only have to make a single, smaller monthly payment. Unsurprisingly, this strategy is referred to as debt consolidation (and sometimes as refinancing).
Banks, credit unions, and online lenders offer debt consolidation loans. Their terms vary.
When you take out a credit-builder loan, it goes into a savings account that you can’t access until you’ve paid the loan off (which usually takes 6–24 months). 13 Your credit score then improves as you make timely payments to pay off the debt.
Because you don’t actually get access to the money until you’ve paid off the loan, credit-builder loans present little risk to lenders, which is why they’re available to people with below-average credit scores.
Pros and cons of installment loans
Like all types of credit, installment loans have pros and cons. Whether they’re the right choice for you depends on your financial situation.
Pros of installment loans
Since installment credit accounts usually have lower interest rates than revolving credit accounts (including credit cards), they’re more suitable for large expenses that will take a while to repay.
Also, by taking out an installment loan instead of using revolving credit, you can avoid increasing your credit utilization rate (the percentage of your available credit that you’re using), which protects your credit score.
Moreover, if you have a fixed-rate loan, your payment size will remain the same every month. This predictability makes it easy to budget and avoid missing payments.
Cons of installment loans
Installment loans aren’t as flexible as revolving accounts. If you realize the loan wasn’t sufficient for your needs, you can’t withdraw any more money. This is in contrast to credit cards, where you can keep withdrawing until you hit your credit limit.
In addition, installment loans may involve other fees and penalties such as application fees, credit check fees, and prepayment penalties. 16 17 This isn’t unique to installment credit; revolving credit accounts sometimes feature similar fees.
How does installment credit impact your credit score?
Your credit score will be affected when you:
Apply for a loan
Applying for an installment loan will trigger a credit check called a hard inquiry. Hard inquiries lower your credit score by a few points (generally fewer than five). 18
A single inquiry isn’t anything to worry about, but there is a point at which you can have too many hard inquiries, so try to only apply for loans when you actually need them.
Get approved for a loan
Getting a new loan lowers the average age of your credit accounts. Because the credit scoring models factor in the length of your credit history, this can result in a temporary drop in your credit score. 19
However, if you previously had no installment loans, taking one out will also increase your credit mix—the balance of installment credit and revolving credit on your credit report. This will boost your score. 20
Repay the loan
Timely loan repayments build your payment history, increasing your credit score. Once you’ve paid off most of your loan, you’ll receive another boost to your score because the major scoring models reward you for having an installment loan that’s mostly paid off. 21