Installment loans: What they are and how they work

An installment loan is a common way to borrow money. Generally, a lender provides a lump sum, which the borrower then repays over time in smaller, equal amounts. The loans get their name because the fixed payments are called installments. 

What you’ll learn:

• An installment loan is a type of closed-end debt.

• Installment loans could have fixed or variable interest rates.

• Personal loans, auto loans, mortgages and student loans are all examples of installment loans.

• Installment loans differ from revolving lines of credit, such as those from credit cards.

Installment loans, also known as installment credit, are closed-end loans for fixed amounts of money. Payments are typically made at regular intervals for the same amount.

Some installment loans are geared toward specific financial goals, such as buying a house or paying for college. Others can be used however the borrower chooses.

If you’re approved for an installment loan, you usually receive the money you’re borrowing at the start of the loan. If it’s a loan to buy property, the money might then go immediately to the seller.

Payments typically include interest charges and are made at regular intervals. They are called “closed end” because once the loan is paid back, the account is closed.

Lenders take creditworthiness into account when deciding whether to offer installment loans. Creditworthiness can also affect interest rates and terms offered.

Installment loans can take many forms. They can be secured or unsecured, depending on whether collateral is involved. Interest rates, repayment terms, fees and potential penalties also vary. Here’s a closer look at some types of installment loans:

Personal installment loans don’t typically have to be used for a particular purchase. They can be used to consolidate debt, make home or car repairs, pay unexpected bills and more.

Auto loans are used to pay for vehicles, which also act as collateral for the loan. Auto loans usually have fixed interest rates. Repayment periods depend on individual loans, but according to the Consumer Financial Protection Bureau (CFPB), “longer loans are more likely to result in your owing more than the vehicle is worth.”

A mortgage is a secured loan used to buy a house. There are different types of mortgages, but the CFPB says most are repaid over 15, 20 or 30 years.

Student loans are unsecured and help pay for undergraduate, graduate and other forms of postsecondary education. Unlike with other installment loans, borrowers usually don’t have to start repaying student loans right away.

Some merchants offer BNPL options at checkout. They let buyers spread out payments instead of paying in full right away. Repayment schedules depend on the merchant, lender and purchase.

A payday loan generally describes a short-term, high-cost small personal loan designed to be repaid quickly. The terms and structure can vary by state, payday lender and individual loan. Payday loans can be high interest, which is why they’re banned in some states.

In exchange for a payday loan, the borrower usually gives the lender a postdated check for the full amount borrowed, plus fees. Or the borrower might authorize the lender to electronically withdraw that amount from their bank account on the due date.

Installment loans could affect your credit scores in a few ways. First, applying for a loan could trigger a hard credit inquiry, which could make your credit scores dip temporarily. Second, if you’re approved for an installment loan, it could contribute to a diverse credit mix. Third, if you’re making payments on time, that could help you build credit.

Unlike installment credit, revolving credit is open end. This means it can be used and paid down repeatedly for as long as the account remains open and in good standing. Some examples of revolving credit accounts include:

1. Credit cards: They allow cardholders to borrow against a set credit limit. 

2. Personal lines of credit: A PLOC, for short, also has a set credit limit. But borrowers typically access funds with special checks or a deposit to their checking accounts.

3. Home equity lines of credit: A HELOC is an open-end credit account that’s secured using the home as collateral.

Installment loans are closed-end loans that are delivered in a lump sum and paid back in regular increments over time. If you’re considering an installment loan, understanding how it could affect your credit could help you determine if it’s the right move.

You can request free copies of your credit reports from AnnualCreditReport.com.

You can also use CreditWise from Capital One. It’s free to all—even if you don’t have a Capital One credit card. It has tools to help you understand your credit score and keep up with changes to your credit report. And with the CreditWise Simulator, you can even see the potential impact of opening new loans before you apply.