What are installment loans and how do they work?

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Editor’s Note: This story originally appeared on The Penny Hoarder.

An installment loan is a lump sum of money that you borrow and then repay at fixed intervals. Installment loans are often used to finance a major purchase, such as a house, car or boat, or to fund education, although you can get an installment loan for almost any reason.

If you’re wondering what an installment loan is, you’ve come to the right place. Learn more about how installment loans work, the pros and cons, and how to get an installment loan.

What is an installment loan?

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An installment loan is a type of loan that lets you borrow money and pay it back in equal monthly installments or another predetermined schedule. You repay the principal loan amount, plus interest, in fixed monthly installments until you have repaid the loan.

Installment loans usually have a fixed interest rate that does not change for the life of the loan. However, some installment loans, such as private student loans, have a variable interest rate that can change while you pay off the loan.

Some installment loans also charge an origination fee to process your application. Depending on the type of installment loan, you may have to pay a prepayment charge if you prepay the loan. But if you don’t make payments according to the repayment terms or make late payments, you could incur additional charges and hurt your credit score.

Installment loans work differently from revolving credit, like a credit card. Revolving credit, like a credit card or line of credit, lets you borrow money and pay it back over and over again, while making payments on an installment loan until it’s due. refunded in full. Payday loans are also different from installment loans in that you repay a payday loan in a lump sum instead of fixed installments.

Types of installment loans

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Installment loans can be secured loans, which means they are backed by collateral, or unsecured loans, which are not backed by collateral. Mortgages and auto loans are two types of installment loans that are secured. Examples of unsecured installment loans include student loans, personal loans, and debt consolidation loans.

Mortgages

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A mortgage is one of the most common types of installment loans used to purchase a house, condo, or land. Most mortgages are repaid at fixed interest rates over 15 or 30 year terms. Your home is collateral for a mortgage, so if you don’t make the payments, your lender can foreclose on your property.

Car loans

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Auto loans are also installment loans which are secured loans. Since your vehicle serves as loan security, it can be repossessed if you don’t repay your car loan. Repayment terms generally range from 24 months to 84 months, with the most common being 72 months.

Student loans

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A student loan is an installment loan, whether you borrow from the federal government or a private lender. The standard repayment term for a federal student loan is 10 years. Federal student loans have a fixed interest rate. For private student loans, repayment terms vary by lender. Private student loan interest rates can be fixed or variable.

Personal loans

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A personal loan is a form of installment credit that you can take out for almost any reason. You borrow a lump sum of money and then repay it at regular intervals. Common reasons for taking out a personal loan include medical bills, home improvement projects, debt consolidation, or paying for a wedding or vacation.

debt consolidation loan

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A debt consolidation loan is a personal loan you use to combine multiple debts into one monthly payment, often at a lower interest rate. Since more of your monthly payment goes toward the principal balance, a debt consolidation loan can reduce the time it takes to pay off debt. APRs range from 6% to 36%, depending on your credit score.

Home Equity Loans

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A home equity loan, or second mortgage, is a type of secured loan that lets you borrow against the equity in your home. You repay it at a fixed interest rate on a set schedule. It is similar to a home equity line of credit (HELOC) in that both allow you to borrow against the equity in your home, however, a HELOC is a type of revolving credit that usually has a rate of varying interest.

Buy now, pay later

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Buy now, pay later services like Klarna and AfterPay offer a form of tiered credit. You typically split the purchase price into four interest-free installments. Installment payments are charged to your debit or credit card.

Advantages of the installment loan

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Installment loans have several advantages and disadvantages that you should be aware of.

Here are the benefits:

  • Predictable payments. Personal loans have a fixed repayment schedule and most have fixed interest rates. As you know the amount of your monthly payments, you can integrate them into your budget.
  • Lower interest rates. Installment loans often have competitive interest rates that are much lower than credit card interest rates, especially if you have good credit. The best installment loans have rates as low as 2.99% APR. This is one of the reasons why installment loans are often a good choice for debt consolidation.
  • Allow you to finance major purchases. An installment loan is often the only way to borrow enough to finance a major purchase, such as a house, car or boat.
  • Less impact on your credit score. Taking out an installment loan hurts your credit score less than charging a credit card or line of credit. Your credit utilization rate, or the amount of open revolving credit you use, is 30% of your credit score. You want your credit utilization to be as low as possible. Unlike revolving credit, installment credit does not affect your utilization rate.

Disadvantages of the installment loan

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And here are the cons:

  • Risk of borrowing too much. Unlike a line of credit where you can borrow as much or as little as you want, with an installment loan you need to decide how much to borrow up front. This could cause you to borrow too much money.
  • Costs. Many installment loans have fees, such as origination fees, documentation fees and prepayment fees, which can increase the cost of borrowing. Missed payments can also result in late fees and hurt your credit.
  • Risk of loss of warranty. Many installment loans are secured loans, which means they are backed by collateral. A mortgage and a car loan are two examples. If you don’t make payments, you could lose your warranty.

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