What are installment loans and how do they work?

There are key considerations for consumers borrowing funds via installment loans versus revolving credit. (iStock)

In the money world, there are two common forms of debt: revolving debt (like credit cards) and installment loans. You may be wondering, "What’s the difference? Isn’t debt just debt?" 

Although both types of debt come with interest costs and monthly payments, they work in very different ways. How you want to use credit will help determine which type is best for you.

Credible lets you compare personal loan rates from various lenders in minutes.

• What are installment loans and how do they work?
• Common types of installment loans
• Benefits and drawbacks of installment loans
• How to apply for an installment loan
• Things to consider before choosing an installment loan
• Can I get an installment loan with bad credit?

What are installment loans and how do they work?

An installment loan is a lump sum of money that you borrow and repay in installments over a set period of time. 

Installment loans are different from revolving debt, where you borrow up to your credit limit on a revolving basis and there’s no set time by which you have to repay the full amount. With installment loans, you get the full amount of money upfront and you have a fixed monthly payment until you pay down the total loan balance. 

With an installment loan, you can’t borrow more than what you’ve been approved for and once you’ve repaid the loan amount in full, you can’t borrow on that loan again. If you need to borrow more money to cover future expenses, you’d have to apply and be approved for a completely new loan. 

What can I use an installment loan for?

Installment loans are incredibly common, and you can use them to pay for large expenses like a car, a home or other major purchase or expense. Installment loans typically come with lower interest rates than credit cards, which is why this type of debt makes sense for bigger, more expensive purchases that could take longer to pay off. 

How much can I borrow with an installment loan?

How much you can borrow with an installment loan will depend on the lender, the type of loan, the loan term and your credit profile. Due to the nature of an installment loan (financing higher-dollar purchases at a lower interest rate), installment loan amounts often go much higher than a traditional credit card limit.

Common types of installment loans

Common types of installment loans include auto loans, mortgages, personal loans and student loans.

Auto loans

Just as the name states, auto loans are installment loans intended to fund vehicle purchases, and you can’t use an auto loan for anything else. The vehicle you purchase serves as collateral for the auto loan.

Most auto loan terms range from 36 to 72 months, with the average auto loan term lasting close to 69 months, according to 2021 Experian data. With auto loans, consumers often get the benefit of choosing a longer repayment period with a lower monthly payment, or a shorter term with a lower interest rate.

Mortgage loans

Mortgage loans are strictly for funding the purchase or improvement of a home, which becomes collateral for the mortgage. The most common terms for mortgage loans are 15 or 30 years. If you take on a 15-year mortgage, you can typically get a lower interest rate, but your monthly payment will be substantially higher as you’re paying off the mortgage in half the time as a traditional 30-year loan.

You can select a mortgage loan with a variable interest rate, but most homebuyers opt for a fixed-rate loan. This way they know exactly how much they’ll owe every month, and their rate won’t change with fluctuations in the market.

Personal loans

You can use a personal loan for a variety of purposes, like home repairs or paying off debt, and they also come with fixed interest rates and term lengths. Many personal loans are unsecured, meaning they don’t require any type of collateral. But they often come with higher interest rates than other types of installment loans.

Student loans

Student loans are intended to fund the costs of higher education, and you can’t use a student loan to pay for non-education-related expenses. Student loans may come from the federal government or private lenders.

The average term for a $30,000 student loan is 10 years, netting out to an average monthly payment of $393, according to EducationData.org. Seems manageable, right? The reason many people struggle with student loans is because the average borrower rarely holds just $30,000 in debt. 

When evaluating student loan lenders, it’s especially critical to do the math to see if the monthly payment fits within your budget. 

Benefits and drawbacks of installment loans

Like any financial product, installment loans have benefits and drawbacks to consider. 

Benefits of installment loans

• The average interest rate for installment loans is typically much lower than average credit card interest rates.
• Installment loans are good for building a strong credit profile; having installment loans (or multiple types of installment loans) creates a mix of credit types, which influences your overall score.
• Making regular, on-time payments each month shows lenders a positive payment history, which also builds healthy credit.

Drawbacks of installment loans

• The application process for an installment loan can be more involved than applying for revolving credit.
• An installment loan can make it difficult to access cash when you need it. For example, if you have a $5,000 installment loan and you pay off $1,000, you can’t access that $1,000 in a pinch.
• Installment loans aren’t always a cheap option; many come with fees, such as origination fees or prepayment penalties if you pay off the loan early.

How to apply for an installment loan

You can apply for an installment loan with an online lender, or in person at a brick-and-mortar bank or credit union branch. You’ll likely need to provide the following documentation when applying for an installment loan:

• Identification, such as a driver’s license or passport
• Proof of income, such as tax returns, W-2s or pay stubs
• Proof of employment (self-employed individuals can utilize tax returns)
• Proof of address, such as a utility bill or copy of your lease

After underwriting (the process where a lender vets your application internally), you can typically receive your installment loan funds fairly quickly once you’re approved. Most mortgage loans close within 30 to 45 days of application, and many personal loan lenders can distribute funds in as little as one to three business days.

With Credible, you can compare personal loan rates from various lenders in minutes without affecting your credit score.

What lenders consider when you apply for an installment loan

When considering your loan application, a lender will evaluate the following:

• Credit score — The minimum score required for an installment loan will vary by lender, but you’ll typically need a minimum score of 600 to qualify. Credit history is very important to lenders who see your past credit history as an indicator of how you’ll handle new debt.
• Debt-to-income ratio — Your DTI ratio is the ratio between how much you make and how much monthly debt you have. Lenders typically like to see a DTI of 36% or less. To get a rough estimate of your DTI ratio, add up all your monthly debt payments and divide that number by your monthly (after tax) take-home pay.
• Income and employment history — Lenders like to see steady employment and a solid income history so they feel reassured that you’ll be able to repay the money they’re lending you.

Things to consider before choosing an installment loan

Not all installment loans are created equal. In order to ensure a loan is the best fit for you financially, here are some things to consider before you sign on the dotted line.

• Interest rate — This is the rate lenders charge for the money you borrow.
• APR — Although you may see APR and interest rate used interchangeably, they’re not the same thing. Annual percentage rate incorporates both the loan interest rate and any fees or costs associated with the loan — so it’s a better picture of the total cost of a loan.
• Fees — Interest isn’t the only money you’ll pay for a loan. Installment loans may also come with fees, including origination fees and prepayment penalties.
• Loan term — This is how long it will take you to repay the loan. Depending on the type of installment loan you have, terms can range anywhere from three to 30 years.
• Monthly payment amount — Ask yourself if the monthly payment for the installment loan fits within your budget and whether you can commit to the repayment schedule.
• Prequalification — Before doing a full review of your personal finances, a lender will look at your credit score and income/debt estimation to prequalify you for a loan. Getting prequalified can help you shop for a car or a home with ease, as you’ll have an estimate of what you can afford and how much your monthly payment might be.

In order to get the best deal on an installment loan, it’s important to shop for a loan in much the same way you’d shop for a car or home. If you get rates from two to three lenders, you’ll be able to see which one offers you the lowest interest rate, the best terms or the lowest fees. 

If you’re ready to apply for an installment loan, use Credible to compare personal loan rates.

Can I get an installment loan with bad credit?

It’s possible to get an installment loan with bad credit, but you probably won’t receive the best rate or loan terms. Your credit score is a big factor when lenders determine what interest rate you’ll receive, and subsequently how much you’ll pay for the loan over time. 

For example, if you have a 600 credit score and you receive a 7% interest rate on a five-year, $10,000 loan, your monthly payment would be $198 and you would pay $1,881 in total interest. If you have a 740 credit score and receive a 5% interest rate with the same loan amount and terms, your monthly payment would only be $189, your total interest would be $1,323, and you would save $558 over the life of the loan.

Because even a slight difference in interest rate can affect how much you pay over the life of the loan, if you have thin credit, it may be best to work on raising your score before applying for an installment loan in order to obtain the best rate possible. 

You can visit Annualcreditreport.com to get a copy of your credit report for free from the three main credit bureaus — Equifax, Experian and TransUnion. Examine them for any errors, and dispute them if anything looks incorrect. If you have an unmanageable debt burden, credit counseling can be another option for improving your credit score.

Installment loans vs. payday loans

Payday loans are technically a type of installment loan because you do repay them in installments. But this is where the similarities end. 

Payday loans come with shorter repayment terms and incredibly high fees that can equate to an APR of 400% or more. These small loans are offered at terms that are highly favorable to the lenders because you can get a payday loan without a credit check or high credit score. You should only consider these loans as a last resort because they can trap you in a cycle of debt and you can end up repaying far more than the amount you originally borrowed.