Installment credit is a loan for a specific amount of money which is repaid in fixed monthly payments over a defined period. Auto loans are a common form of installment credit in which you borrow a specific dollar amount to buy a car and pay it back over a period of years. You subsequently repay the loan amount plus interest in a given term, like 60 or 72 months.
Installment credit differs from revolving credit, including credit cards and lines of credit, because you must establish a set amount of money you wish to borrow. The repayment period can last from a few months to several years until the loan is paid in full.
If you’re thinking about getting installment credit, it’s helpful to know the different types of installment loans available, their pros and cons and how they differ from revolving credit.
What Are the Different Types of Installment Loans?
Some of the most popular loans consumers use are installment loans, including the following:
Auto loans are installment loans that usually require a down payment. The car itself serves as the collateral to secure the loan.
Typically, the loan term is between 36 and 72 months, although the period can go up to 96 months depending on the loan principal and your financial situation. Generally speaking, longer loan terms feature higher interest rates.
Mortgage loans help home buyers purchase a home and come with fixed or adjustable interest rates. Like auto loans, mortgage loans require a down payment.
The house serves as the collateral so if you are not able to make payments, the lender could foreclose on your home. Home loans are generally for 15 or 30-year terms, though other terms exist.
Student loans are used to cover the costs of your education. Upon your graduation, you must repay the lender in loan installments over a set period of time.
The standard repayment schedule for federal student loans is 120 months (10 years) with fixed payments over the term of the loan.
Some students arrange different payment schedules with their lenders. According to a Department of Education report, the normal repayment period for borrowers with federal student loan debt between $20,000 and $40,000 is 20 years.
Unlike most loans, many student loans allow you to defer payments if you become unemployed.
People use personal loans for many different reasons, such as debt consolidation, medical emergencies or to finance home improvements. The loan term is usually between 12 and 96 months.
Because these loans are unsecured, meaning no collateral is necessary, they often carry high-interest rates.
If your credit is excellent, you may be able to secure a personal loan from your bank or credit union. Take caution, though, before you make any decision to turn to a payday loan company. These companies charge exorbitantly high-interest rates as well as extra fees.
What Are the Benefits and Downsides of Installment Credit?
As with most financial decisions, you’ll want to weigh the pros and cons of installment credit before applying for one of these loans.
Perhaps the biggest benefit of installment credit is the predictable nature of the loan payments. When you open a fixed-interest rate loan, your payments are likely to be for the same amount each month for the duration of the loan term. It’s easy to fit your payments within your budget when they are for the same amount each month.
Knowing your loan payoff date is another benefit. It’s reassuring you know exactly when the loan will be paid off, so long as you make payments on time.
Consider getting a loan with the shortest loan term you can afford, to pay off the loan earlier and reduce the amount you pay in interest.
Perhaps the biggest downside to installment loans is the higher interest rates they usually carry. While installment loans help you pay off other debts, you pay a price for that benefit in the form of increased interest rates.
While installment loans are predictable, they may provide you with less flexibility. In other words, you can’t add more to your loan as you can with credit cards. If you need more money, you’ll have to apply for a new loan.
Another drawback is the rates and terms you receive are dependent on your credit. If your score is less than perfect, you’ll likely have to pay more in interest and more for the total loan amount than those with excellent credit.
Unfortunately, predatory lenders target borrowers with poor credit. These loan companies, which include payday loan businesses, offer fast installment loans with excessive interest rates, high fees and hidden costs.
What Are the Differences Between Installment Credit and Revolving Credit?
Installment credit, such as mortgages and auto loans, involve making regular payments for the same amount every month until the loan is paid off. Neither your payment or the total amount you owe will change. Once the installment credit is paid in full, the account is closed.
In contrast, revolving credit doesn’t have a fixed monthly payment and doesn’t come with a loan term for a predetermined amount of money.
Revolving credit, such as credit cards and home equity lines of credit, includes a balance limit to how much you can borrow, but you can choose how much of the balance you wish to use.
How Does Installment Credit Affect Your Credit Score?
Like other forms of credit, credit scores tend to fall temporarily when borrowers get an installment loan. The credit score drop is usually because these debtors will have less disposable income when they open a new credit account. Additionally, getting an installment credit usually involves the lender making a hard inquiry on your credit report.
Typically, borrowers’ credit scores bounce back after a few months of timely payments.
Once the installment loan is repaid the lender closes the account. Closed accounts in good standing remain on credit reports for 10 years, potentially benefiting the borrowers’ credit health during that time.
Smart Options to Costly Installment Loans
Most installment loans, and particularly payday loans, come with higher interest rates than personal loans from banks and credit unions. If you’re looking for a more affordable option, consider these alternatives:
Credit Union Loans
If your credit score is less than perfect, a credit union may be able to help you with a small-dollar installment loan. For these loans, the interest rates cap at 15% by law.
Credit Builder Loans
Credit builder loans help those with little credit history, or whose credit score falls below 630. The payments you make are reported to the three major credit reporting agencies: Equifax, Experian and TransUnion.
Payday Alternative Loans
Some credit unions offer payday alternative loans (PALs) to their members. These loans are usually for smaller dollar amounts with costs that are usually considerably lower than what most payday loans offer.
The Bottom Line
Installment credit may provide a path for you to achieve a financial goal, like owning a home or buying a car. The key benefit of these loans is having a fixed loan amount, with fixed monthly payments, during a fixed loan term. None of these factors will change unless you decide to pay more to repay the loan sooner.
Before you apply for an installment loan, it may be wise to check your credit score to see what kinds of interest rates you might receive. If you wish to proceed, shop around for the best rates and terms to suit your needs.