July 19, 2024

What are Installment Loans and How Do They Work?

Taking out a loan is an intimidating leap, no matter what your financial situation it’s from. But, choosing an installment loan can ease the payback process.

But what is an installment loan, and how does it work? Here’s everything you need to know about this loan type to decide if it’s a good choice for you.

What is an installment loan?

An installment loan is a financial product that lets you borrow money, typically in a lump sum, and repay it over a set period in regular installments. These loans stand out for their flexibility, structured repayment plans, and ability to adapt to your repayment capacity — making them a popular option for managing significant expenses with few surprises.

How does an installment loan work?

When you secure a personal installment loan, you borrow a specific amount of money from a bank or other lender. In exchange, you commit to paying back the loan, plus interest, over a set period through regular installments — usually monthly.

In most cases, you’ll encounter a fixed interest rate, which means the interest rate won’t increase over time. If your original rate is 10%, it’ll stay at 10%. This makes for more consistent payments throughout the loan’s life. Each payment you make reduces both the principal amount and the interest until you’ve fully paid it off.

To get an installment loan, you have to submit an application. The lender evaluates your creditworthiness by examining your credit score, income, and other financial parameters. If they accept your application, the lender gives you the funds as a lump sum or applies them directly to the loan’s purpose, like a car loan or mortgage.

Are revolving lines the same as an installment loan?

What’s an installment loan like compared to a revolving line of credit? Revolving credit and installment loans serve different financial needs.

With revolving credit, you’re given a credit limit, or a maximum amount you can borrow. Credit cards are a common example. They allow you to borrow as much or as little as you need up to that limit and you only pay interest on the amount borrowed but can’t pay back, like a credit card.

In contrast, installment loans involve borrowing a fixed amount of money all at once and repaying it over time in set installments. You and the lender set the repayment terms at the beginning of the agreement, including the interest rate and the number of payments.

While you can use both of these tools to manage cash flow and finance purchases, knowing the differences helps in making informed decisions about which type of credit best suits your financial needs. Revolving credit is helpful, but it likely won’t be enough to cover a big purchase like a home. Installment loans are great options for larger expenses, not day-to-day spending.

4 examples of installment loans

Each of these common types of installment loans can have varying repayment terms, interest rates, and amounts. These factors depend on the lender and your credit score.

1. Personal loans

Personal loans are unsecured, which means they don’t require collateral. They don’t have to go toward something specific, like a car or home. They’re versatile and can cover various purposes, including consolidating debts or funding home improvements. It’s a flexible option for people looking to address immediate needs without tying up an asset, and the approval process is usually relatively quick.

2. Student loans

Tailored for educational expenses, student loans come with features that help students overcome financial constraints. They often have lower interest rates and flexible repayment options, including grace periods post-graduation, so payments aren’t due until a set amount of time out of school. This allows students to focus on education before transitioning into the professional world and beginning repayments.

3. Mortgages

Mortgage loans are secured loans specific to property purchases. The property itself serves as collateral, offering the lender security against the loan — meaning if you don’t pay the installments, the lender has the right to take that house or property from you.

Homes are expensive enough that most people can’t afford to pay out of pocket, and mortgage loans make home owning more accessible. Individuals and families gain home equity and a place to live, and once they pay off the mortgage, they own the home officially. Terms and annual percentage rates (APR) vary based on the borrower’s creditworthiness and the lender’s criteria. Using a mortgage loan calculator, can help you estimate your monthly payments and plan your homeownership journey.

4. Auto loans

Auto loans are another form of secured loan where the purchased vehicle serves as collateral. Similar to a mortgage, this loan type lets you own and pay for a vehicle over time, giving you the advantages of using a car without a substantial upfront financial burden. You can arrange an auto loan with a lender or with the company you’re buying from. To help you plan and manage your auto loan, consider using a tool like Earnin's auto loan payoff calculator.

Pros and cons of installment loans

Although installment loans are an effective way to make large purchases without paying huge sums, they do have their downsides. You have to commit to regular payments, and there could be penalties if you don’t keep up. Here are some pros and cons of choosing installment loans.

Pros

-Finance large purchases. Installment loans can be essential if you don’t have the funds to make a large purchase on your own. With a loan, you can purchase assets like vehicles, pursue higher education, or become a homeowner without providing the total cost upfront. You can then comfortably repay the loan in smaller, manageable amounts over a specified period.
-Improve your credit. Repaying your loan in a timely and consistent manner has a positive impact on your credit score. Each on-time payment is reported to the credit bureaus, showcasing your reliability and creditworthiness, which can benefit future financial purchases and loan approvals.
-Pay a consistent amount. If your loan has a fixed interest rate, your repayment amount will stay the same over the loan period. This can help your financial planning and budgeting because you’ll know the exact amount due each month, which is particularly beneficial compared to other debt types like credit card debt and payday loans. Borrowers dealing with these debts often face variable interest rates and unpredictable monthly payments, making financial planning difficult.

Cons

-Commit long-term. Installment loans require a long-term financial commitment. You must adhere to the payment schedule for the entire loan duration, which can become a challenge if there’s a change in your financial status.
-Potentially damage your credit. Lenders report your payments to credit bureaus, so if you’re late or miss a payment, your credit score will suffer. When taking on an installment loan, you have to be ready to pay on time every month and manage your finances accordingly. Even a few missed payments can have big consequences.
-Face penalties. If you try to pay off the loan early to save on interest, you might face prepayment penalties. These additional fees can sometimes offset the benefits of early repayment, so it’s essential to understand the loan terms thoroughly before overpaying.

How installment loans affect your credit score

An installment loan can be a double-edged sword when it comes to your FICO Score or VantageScore. On one hand, if you manage it responsibly, it can be a tool to build or improve your credit. But mismanagement can lead to a decline in your credit score.

When it’s time for an installment, your lender will report it to credit bureaus. If you’re on time, your score goes up, and if you’re late, the score goes down. A couple of missed payments aren’t necessarily a big deal, but credit bureaus see your loan behavior as a sign of your reliability — so if you’re consistently late, your credit score could drastically lower. This could make you ineligible for future loans, credit cards, or even certain jobs.

Consistently repaying your loan can boost your VantageScore, so if you’re confident in your ability to make those payments, an installment loan is a good financial decision. It diversifies your credit mix, showing you can manage different types of debt, from credit cards to secured and unsecured loans. Credit bureaus will see your reliability and boost your score.

Applying for an installment loan in 4 steps

The application process for an installment loan can be straightforward if you’re prepared. Here’s how to make an informed decision:

1. Explore a loan calculator

Before applying, it can be helpful to use a personal loan calculator to estimate your potential monthly payments and the total cost of the loan. This gives you a clearer picture of your financial commitment and what loan terms might be realistic for you. For example, you might find that even with a high down payment, you can’t afford an auto loan with more than 8% interest.

2. Choose a lender

Once you know what type of loan you’re looking for, research potential lenders. These could range from traditional banks and credit unions to online lenders. Each will have its specific criteria, interest rates, and loan terms — so compare options to find the one that best suits your financial needs and creditworthiness.

3. Gather necessary information

Gather all the documentation you need before applying. Lenders typically require proof of income, a credit report, and information on your debts and assets. Your credit score is pivotal in the lender’s decision and the interest rate it’ll offer you, and a higher credit score can lead to more favorable terms, like lower interest.

Even if your credit history could be better, obtaining an installment loan with bad credit is still within reach. While it might be more challenging, lenders are willing to work with people who have lower credit scores. Just be aware that these loans may come with higher interest rates and more stringent terms to compensate for the increased risk the lender takes on.

4. Complete the application

Once you’ve selected a lender, complete the application process. You can usually do this online, but it’s a good idea to meet with a lender in person and ask any questions you have face-to-face.

The lender will review your application, and if approved, will present you with the loan terms. Review these carefully, paying close attention to the interest rate, repayment schedule, and potential fees, like origination fees. Only agree to the loan if you’re confident that you can pay it off. It’s not worth it to end up in a high-risk situation.

Open your options with EarnIn

If you need help with day-to-day spending or unexpected expenses, a loan isn’t your only option. When you need cash quickly, Earnin’s Cash Out tool can get you paid as you work.

Unlike traditional installment loans or revolving credit lines, EarnIn provides an innovative solution that connects with your pay cycle. You can access your pay as you earn it, offering a cushion to navigate expenses or strategically reduce your debt. And our Credit Monitoring tool allows you to keep a close eye on your credit score at any time — for free.

Add the EarnIn app to your financial toolkit and experience money at the speed of you.

Please note, the material collected in this post is for informational purposes only and is not intended to be relied upon as or construed as advice regarding any specific circumstances. Nor is it an endorsement of any organization or services.

1. Calculated on the VantageScore 3.0 model. Your VantageScore 3.0 from Experian® indicates your credit risk level and is not used by all lenders, so don't be surprised if your lender uses a score that's different from your VantageScore 3.0. Learn more: https://www.experian.com/assets/consumer-information/product-sheets/vantagescore-3.pdf