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What Are Installment Loans?

What Are Installment Loans?
Kelly Boyer Sagert
Kelly Boyer SagertUpdated April 21, 2023
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
An installment loan is a common type of loan where you borrow a set amount of money that you then repay in regular amounts over a fixed period of time. In fact, there’s a good chance you’ve taken out this type of loan, as installment loans are often used to fund a big purchase such as a house, a car, or college tuition.Read on for a more in-depth installment loan definition and an explanation of how they work, as well as a rundown of their pros and cons and how you can apply for one.

Installment Loan Definition

With an installment loan, someone borrows a lump sum of money when they take out the loan. Then, they pay back the loan in regular installments over a specified period of time, typically months or years. Payments on installment loans include principal and interest in a monthly amount that typically remains the same throughout the loan’s term.An installment loan can be a secured loan, which means that you give the lender a collateral pledge to back up the loan, such as pledging your home or car you own, or they can be an unsecured personal loan, which does not require collateral.

How Installment Loans Work

Borrowers typically take out an installment loan because they want to make a large purchase, such as a car or house, and, to afford that purchase, they need its cost broken down into installments.The lender will typically take the amount borrowed (the initial balance) and divide it — or amortize it into — a series of principal and interest payments. The amount of those payments will depend on several factors, including the initial loan amount, the interest rate charged, your credit score, and the loan’s term (the number of payments you’ll make over the life of the loan).When comparing an installment loan vs. revolving credit, the key difference is that with an installment loan, you receive a lump sum of money to use in the approved way and then pay it back in monthly installments. With revolving credit, such as a credit card or line of credit, the borrower receives approval for a certain dollar amount that they can draw upon as needed, with payments fluctuating depending on the balance used.Recommended: Average Credit Card Interest Rates in 2023

Principal Amounts

With each installment payment you make, money first goes toward satisfying the interest. The rest then goes to the loan principal, reducing the balance.This means that early on, more of the money paid will go toward interest. This is because the interest owed is calculated each month based on the remaining balance. Thus, the amount owed for interest will incrementally decrease, allowing a greater percentage of the payment to go toward paying down the principal.

Interest Rates

When calculating the amount of interest you’d pay on your loan during a particular month, the financial institution may take your interest rate and divide it by 12, which gives them your monthly interest rate. Your remaining principal balance is then multiplied by this monthly interest rate, with the result being how much you’ll owe in interest that month. The higher your interest rate, the larger this figure will be.

Credit Score Requirements

Although each lender will have different requirements, a high credit score generally allows you to qualify for a better interest rate — and, as described above, this means you’ll owe less in interest. When you have a good to excellent credit score, the lender perceives loaning you money as a lesser risk, and this is reflected in the interest rate they approve.

Repayment Terms

When a lender calculates a loan payment, three factors enter into the calculation:
  • The amount borrowed
  • The interest rate charged
  • The length of the loan
All other things being equal, a longer term will allow you to have a lower monthly payment, but you’ll pay more in interest over the loan’s life. A shorter term means a higher monthly payment but less overall in interest paid.

Monthly Payments

The lender will use the inputs described above to calculate a monthly payment that, when all payments are made according to the amortization schedule, cause the borrower to pay off the principal in full at the end of the loan’s term. The final scheduled payment is also known as the loan maturity date.

Four Types of Monthly Installment Loans

Here are four examples of monthly installment loans:
  • Personal loans
  • Home loans
  • Student loans
  • Auto loans
Read on to learn more about each of them:

1. Personal Loans

Borrowers take out personal installment loans for a variety of reasons. Purposes can include paying off medical or other other unexpected bills, consolidating credit cards and/or other debts and making car or home repairs, among other uses.In general, personal loans are unsecured, meaning they aren’t backed by collateral. Because there’s nothing backing them, unsecured loans tend to have higher interest rates.

2. Home Loans

Home loans, also called mortgages, come in a number of different types, including conventional mortgages, government-backed mortgages such as VA and FHA loans and, for large loans that exceed Federal Housing Finance Agency (FHFA) limits, jumbo loans. A mortgage may have a variable interest rate, which means principal and interest payments will fluctuate according to the rate, or the rate can be fixed.Home loans are secured, so if the borrower doesn’t make payments, the lender may foreclose on the property.

3. Student Loans

Federal and private student loans are another form of an installment loan. Federal student loans are issued by the federal government and generally include income-driven repayment and loan forgiveness options not available to private student loan borrowers. Financial institutions that offer private student loans set their own interest rates and terms.

4. Auto Loans

Auto loans are another type of secured installment loan in which the vehicle is typically used as collateral during a purchase or a refinance. With auto refinancing, the borrower takes out a new loan to pay off the balance of the old one. From that point on, the interest rate and terms of the new loan apply; as such, refinancing to a lower interest rate can result in savings in the long run.

Pros and Cons of Monthly Installment Loans

Just like with any kind of loan, there are advantages and disadvantages to installment loans:

Pros of Installment Loans

  • Flexibility. The flexibility of installment loans allows borrowers to seek money they need at terms that can make it reasonable to repay, allowing consumers to make large purchases.
  • Fixed payment schedule. The fixed payment schedule of installment loans can make it easy to budget for loan payments. Plus, you’ll know when your loan will be paid off.
  • Potentially competitive interest rates. Interest rates are typically lower for installment loans than other options, especially when compared to credit cards and payday loans.
  • Prepayment can allow for interest savings. Paying off the loan more quickly can help borrowers to save money on interest (though be sure to investigate prepayment penalties before proceeding).

Cons of Installment Loans

  • Possibility of going into debt. The ease of borrowing can make it too easy to go too far into debt.
  • Could get stuck with a higher interest rate. On long-term loans with a fixed rate, market interest rates can go down during the term, but the borrower will still be paying the original higher rate unless they refinance.
  • Can cause financial damage if unpaid. If the consumer can’t meet the obligation, their credit scores may be harmed and they may even go into default. Additionally, if the loan is secured, collateral may be seized.
  • Fees. Installment loan fees can be costly. 

Installment Loans vs Payday Loans

Installment LoansPayday Loans
Comparatively lower interest ratesTypically much higher interest rates
Loan amount can range into the tens of thousandsLoan amounts are typically just a few hundred dollars
Repayment terms can range from months to yearsRepayment terms are very brief, usually no more than a few weeks
With a payday loan, a lender approves a certain dollar amount with a short repayment term, often no more than a few weeks. The term will usually end on the borrower’s payday (thus, the name) to help ensure that the funds will be there to pay off the loan.An installment loan, in comparison, typically has a longer term than a payday loan — often significantly so. Approval can be super fast with a payday loan, and there’s typically no credit check involved like there is with an installment loan. However, before the lender deposits the money into the borrower’s account, the consumer generally must write the lender a postdated check for the full amount of the loan payoff. So, although this check won’t be cashed until the end of the payday loan’s term, the borrower is essentially paying the loan off before receiving the funds.Payday loans come with high annual percentage rates, much higher than a typical installment loan. Loan amounts are also generally much lower than they can be for installment loans.

Alternatives to Installment Loans

Wondering what options you have outside for an installment loan? Here are some installment loan alternatives to consider that could be right for your situation:

Typical Installment Loan Application Process

Although processes vary by lender, applying for an installment loan typically requires sharing your personal information, such as your:
  • Name
  • Address
  • Telephone number
  • Social Security number
  • Date of birth 
Lenders will usually want information about your financial situation and may ask for proof of income (pay stubs, bank statements and/or tax returns).Additionally, lenders will verify your identity, perhaps through your driver’s license or other state-issued ID and your Social Security card. They may accept military IDs, passports, and birth certificates.Depending on whether you’re applying for a secured or unsecured loan, the lender will want information about the collateral, whether that’s a car or house or something else.The financial institution will then review your application and let you know whether you’re approved and, if so, under what rate and terms.

Compare Personal Loan Rates Today

As you can see, installment loans can come in handy for large purchases, though there are pros and cons to consider before borrowing money. You’ll also want to understand the terms and conditions you’re agreeing to. Types of installment loans you can get include auto loans, student loans, home loans and personal loans.If applying for a personal loan is your goal, then you can fill out just one form at Lantern by SoFi to get personal loan offers from lenders in our marketplace. Applying is quick, easy, and convenient with no application fee.Compare personal loan rates and apply in minutes.
Photo credit: iStock/shapecharge

About the Author

Kelly Boyer Sagert

Kelly Boyer Sagert

Kelly Boyer Sagert is an Emmy Award-nominated writer with decades of professional writing experience. As she was getting her writing career off the ground, she spent several years working at a savings and loan institution, working in the following departments: savings, loans, IRAs, and auditing. She has published thousands of pieces online and in print.
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