What are installment loans and how do they work?
Editor’s Note: This story originally appeared on The Penny Hoarder.
An installment loan is a sum of money that you borrow and then pay back at set intervals. Installment loans are often used to finance a major purchase such as a house, car or boat, or to finance an education, but you can get an installment loan for just about 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?
An installment loan is a form of loan where you can borrow money and pay it back in equal monthly installments or on some other specified schedule. You pay back the principal plus interest in fixed monthly installments until you repay the loan.
Installment loans usually have a fixed interest rate that does not change over the life of the loan. However, some installment loans, like personal student loans, have a variable interest rate that can change as you pay off the loan.
For some installment loans, there are also processing fees for processing your application. Depending on the type of installment loan, prepayment penalties may be due if you repay the loan early. But if you don’t make payments according to the repayment terms or are late in making payments, you could incur additional charges and affect your credit score.
Installment loans work differently than revolving loans, like a credit card. A revolving loan, like a credit card or line of credit, allows you to borrow money and pay it back over and over again while making payments on an installment loan until it’s paid off in full. Payday loans also differ from installment loans in that you pay back a payday loan in one lump sum rather than in fixed installments.
Types of Installment Loans
Installment loans can be secured loans, meaning they are secured by collateral, or unsecured loans, which are not secured by collateral. Mortgage and car loans are two types of installment loans that are secured. Examples of unsecured installment loans are student loans, personal loans, and debt consolidation loans.
A mortgage loan is one of the most common types of installment loans used to buy a home, condo, or land. Most mortgages are repaid at fixed rates over 15 or 30 year periods. Your home is collateral for a mortgage. So if you don’t make payments, your lender can seize your property.
Auto loans are also installment loans, which are secured loans. Because your vehicle serves as collateral for the loan, it can be repossessed if you fail to make car loan payments. Repayment periods are typically between 24 and 84 months, with 72 months being the most common.
A student loan is an installment loan, whether from the federal government or from a private lender. The usual repayment period 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. Interest rates on private student loans can be fixed or variable.
A personal loan is a form of installment loan that you can take out for almost any reason. You borrow a one-time sum of money and then pay it back at regular intervals. Common reasons for taking out a personal loan include medical expenses, home improvement projects, debt consolidation, or to pay for a wedding or vacation.
Debt Consolidation Loan
A debt consolidation loan is a personal loan that you use to combine multiple debts so you have one monthly payment, often at a lower interest rate. Because a larger portion of your monthly payment goes into the principal, a debt consolidation loan can reduce the time it takes to pay off debt. The effective annual interest rate is between 6% and 36%, depending on your creditworthiness.
A home equity loan, or second mortgage, is a type of secured loan that you can use to mortgage your home equity. You pay it off at a fixed rate over a set schedule. It is similar to a home equity line of credit (HELOC) in that both allow you to borrow against your home equity. However, a HELOC is a type of revolving loan that usually has a variable interest rate.
Buy now, pay later credit
Buy now, pay later services, such as Klara and AfterPay, offer a form of installment credit. As a rule, you divide the purchase price into four interest-free payments. The installment payments will be charged to your debit or credit card.
Installment loan professionals
Installment loans have several advantages and disadvantages that you should be aware of.
Here are the benefits:
- Predictable Payments. Personal loans have a fixed payment schedule and most have fixed interest rates. Since you know the amount of your monthly payments, you can work them into your budget.
- Lower interest rates. Installment loans often have competitive interest rates that are much lower than credit card rates, especially if you have good credit. The best installment loans have interest rates as low as 2.99% APR. That’s one reason why installment loans are often a good choice for debt restructuring.
- This allows you to finance larger purchases. An installment loan is often the only way to borrow enough money to pay for a major purchase like a house, car, or boat.
- Less impact on your credit score. Taking out an installment loan does less damage to your credit score than loading a credit card or line of credit. Your credit utilization ratio, or the amount of open revolving credit you use, accounts for 30% of your credit score. You want your credit utilization to be as low as possible. Unlike the revolving loan, the installment loan does not affect your utilization.
Installment loan cons
And here are the disadvantages:
- Risk of excessive borrowing. Unlike a credit line, where you can borrow as much or as little as you want, an installment loan requires you to decide upfront how much you want to borrow. This could result in you borrowing too much money.
- fees. Many installment loans incur fees, such as B. Processing fees, documentation fees and prepayment fees, which can increase the cost of credit. Missed payments can also result in late fees and affect your credit score.
- Risk of Loss of Collateral. Many installment loans are secured loans, meaning they are backed by collateral. A mortgage and a car loan are two examples. If you fail to make payments, you could lose your collateral.
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