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.

An installment loan, also known as installment credit, is a closed-end loan for a fixed amount of money. The borrower typically makes payments at consistent intervals and amounts until the loan is paid off.

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 full amount of 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 on a regular basis. A part of each payment applies to the principal loan amount, while another part applies to the interest. Installment loans are called “closed end” because once the loan is paid back, the account is closed.

Lenders take the borrower’s creditworthiness into account when deciding whether to offer an installment loan and how to set repayment terms and interest rates.

Installment loans can take many forms. They can be secured or unsecured, depending on whether the loan requires collateral. Interest rates, repayment terms, fees and potential penalties also vary. 

Here are examples of different 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, typically for online or mobile app purchases but sometimes also in stores. These loans allow buyers to 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.

• Applying for a loan could trigger a hard credit inquiry, which could make your credit scores dip temporarily.

• If you’re approved for an installment loan, it could contribute to a diverse credit mix, which could positively impact your credit.

• If you’re making payments on time, that could help you build credit.

Here are some points to consider when deciding if an installment loan is right for you.

The benefits of installment loans include:

• Ability to cover a large expense: Installment loans can offer quick access to money for bigger purchases.

• Predictable, regular repayments: You’ll know what your payment amount is going to be, which can help make budgeting easier.

• Opportunity to refinance: If interest rates fall or if your credit score improves, you could consider refinancing an installment loan like a mortgage or personal loan. This might lower your monthly payments or shorten your repayment period. Keep in mind lenders may charge additional fees for refinancing.

Some possible drawbacks to installment loans include:

• They’re not open-end loans: You probably won’t be able to increase your loan amount.

• They’re potentially long commitments: Certain types of installment loans require you to make regular payments over a long period of time. Keep in mind that there may be prepayment penalties for paying the loan off early.

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 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 provided by lenders in a lump sum and paid back by borrowers in regular increments over time. If you’re considering an installment loan, understanding how it could affect your credit might 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 has tools to help you understand your credit score and keep up with changes to your credit report. And with the Credit Score Simulator, you can even see the potential impact of opening new loans before you apply.