An installment loan is a loan that you pay off over time according to a schedule of monthly payments. Standard home and auto loans are examples of installment loans. These loans have predictable payment schedules, but there are pros and cons of borrowing with installment debt.
Learn what it’s like to use one of these loans, the pros and cons of installment debt, and which alternatives might be a better fit for your needs.
What Are Installment Loans?
Installment loans are loans that you repay with a series of monthly payments. They typically have a fixed interest rate, and each monthly payment is the same. Fixed-rate home and auto loans are the most common types of installment loans, but personal loans, student loans, and other types of loans are also forms of installment debt.
- Alternate name: Closed-end credit
How Does an Installment Loan Work?
Installment loans allow you to make large purchases or consolidate debt using borrowed money instead of your own. With a repayment term that lasts several years (or several decades), the payments are relatively small, making things like homes and automobiles affordable.
An installment loan is generally a one-time loan that provides money in a lump sum. Lenders calculate your monthly payment so that each payment reduces your loan balance and covers your interest costs, eventually bringing your balance to zero over the term of your loan.
In most cases, the lender will let you see what your monthly payment will be before you accept the loan they offer. Additionally, personal loan lenders often provide preliminary monthly payment quotes without affecting your credit.
You pay most of the interest on an installment loan in the early years. Your first few payments only make a small dent in your loan balance, but eventually, you gain momentum, and those payments increasingly pay off your debt.
Installment Loan Example
Assume you borrow $20,000 to purchase a car using a four-year auto loan. With a 4% interest rate, you have 48 equal payments of $451.58. Each payment, known as an “installment,” pays interest charges and helps to reduce your loan balance, or “principal.” But your first payment only pays off $384.91 of your loan balance. The remaining $66.67 of your payment is your interest cost.
Over time, you pay off your loan balance in bigger chunks, and your interest costs decline. After your 48th payment, your loan balance will be zero.
|Month||Starting Balance||Monthly Payment||Interest Cost||Loan Payoff||Ending Balance||Total Interest Paid|
*The final payoff amount is off slightly due to rounding in the calculator.
To learn more about how this works, get familiar with loan amortization and how to build your own amortization tables.
Secured vs. Unsecured Loans
Some loans require you to use collateral when you borrow. For example, with an auto loan, the loan is secured by the vehicle you purchase. If you stop making payments, lenders can take the vehicle in repossession. Home loans are similar, allowing lenders to foreclose on your home.
Unsecured loans do not require collateral. Many personal loans are unsecured loans, meaning there is no asset for your lender to take if you stop making payments. Instead, lenders may report late payments to credit bureaus and take legal action against you.
Types of Installment Loans
- Personal loans: Unsecured personal loans are often available as installment loans. Banks, credit unions, and online lenders offer these loans for almost any purpose.
- Auto loans: When you purchase a vehicle, you typically have a fixed monthly payment for the life of your loan.
- Home purchase loans: Traditional 30-year fixed-rate mortgages and 15-year mortgages are standard installment loans.
- Home equity loans: When you get a second mortgage, you can receive funds in a lump sum and pay off the debt in installments.
- Student loans: Student loans are generally installment loans. Each time you borrow, you typically get a new loan.
- Other types of loans: Installment loans come in numerous variations. They might have specific names, such as RV loans, fertility loans, dental loans, or landscaping loans, but they’re all typically a form of installment debt.
Pros and Cons of Installment Loans
Receive one lump sum
Typically fixed interest rates
Flat monthly payment, in most cases
Known payoff date
Ongoing ability to borrow
Typically variable rates
Monthly payment may vary
Debt elimination may be fast or slow
Monthly Payments Are Fixed in Most Cases
Installment loans usually have a flat monthly payment that does not change. As a result, it’s easy to budget for those payments over the coming years.
Cost of Large Expenses Spread Out Over Time
These loans make it possible to buy expensive things like a home or a car. Unless you have enough money set aside to pay cash, an installment loan might be your only option for buying.
Debt-Payoff Date Is Known in Advance
Unlike credit cards, installment loans have a payoff schedule with a specific number of months. You gradually reduce debt with each payment, and your loan balance will be zero at the end of your loan term.
One-Time Loan Does Not Allow Additional Borrowing
Installment loans are generally one-time loans that provide money in a lump sum. If you need additional funds after you borrow with an installment loan, you may need to apply for a new loan or find other funding sources. Credit cards and other lines of credit allow you to borrow repeatedly.
Borrowing Fees Can Be High
Installment loans may charge fees that add to your cost of borrowing—sometimes substantially. Home loans may have closing costs that amount to thousands of dollars. Personal loans may charge origination fees of 1% to 8% of your loan amount, and that fee comes out of your loan proceeds. Plus, some payday loan shops offer installment loans that can end up costing up to 400% APR.
Although an installment loan has a payment schedule, you can often pay these loans off early with no prepayment penalty.
Limitations of Installment Loans
While loans make it possible to buy a home or pay education expenses, there are drawbacks to borrowing. An installment loan is a monthly obligation. If you’re unable to keep up with the payments, you risk damaging your credit or losing collateral that’s attached to the loan.
Also, life is uncertain, and you might not know exactly how much money you need and when you’ll need it. When you borrow with a one-time loan, you may not be able to qualify for additional loans if you max out your debt-to-income ratios. A credit card or other type of credit line might provide more flexibility.
Alternatives to Installment Loans
If you need to borrow money and you don’t want an installment loan, the primary alternative is a line of credit. Those loans, also known as revolving loans, generally allow you to borrow multiple times until you reach your maximum credit limit. For example, you might borrow with a credit card or a home equity line of credit (HELOC).
Installment Loan vs. Line of Credit
|Installment Loan||Line of Credit|
|Receive one lump sum||Ongoing ability to borrow|
|Typically fixed interest rates||Typically variable rates|
|Flat monthly payment, in most cases||Monthly payment may vary|
|Known payoff date||Debt elimination may be fast or slow|
Installment loans and lines of credit have several similarities. With either type of loan, your credit scores affect your interest rate and other borrowing costs. In general, with better credit, you get a lower APR and may pay lower origination fees. Plus, either type of loan may allow you to pay off your balance early—just research any prepayment penalties before doing so.
- Installment loans allow you to borrow money for major expenses.
- You pay off debt over a predetermined number of months.
- In many cases, your interest rate and monthly payment are fixed, making it easy to budget.
- Installment loans provide one-time funding.
- If you need to borrow and repay multiple times, a line of credit may offer more flexibility.