Loans

How do installment loans work?

People take out loans for different purposes, which is why there are mortgages, car loans, personal loans, and many other types. When you borrow money from a lender, whether it’s a bank, a credit union, or an alternative lender, you must agree to the terms of repayment before you sign the contract and receive the funds.

You can pay off the debt in several ways, the most common being installments. These installments are typically paid monthly, and in many cases, they include both a portion of the principal and the interest. You have a fixed repayment schedule, and as you make payments to your lender your outstanding debt decreases.

However, the installment loans themselves can work in different ways.

Understanding Installment Loans

When you agree to borrow money, you and your lender must determine three key elements of the loan:  How much money you are going to borrow, how long you are going to be repaying it, and at what interest rate. The lender will use these elements to calculate your monthly payment.

The amount of money you can borrow depends on several factors, like your monthly income, your credit score, and the lender’s limit—if they have one. Sometimes, your income will be high enough to allow you to borrow a large sum of money, but if it’s over the lender’s limit, it’s unlikely that you will be approved. Also, with an excellent credit score, you may also get approved for a higher amount of money.

Your interest rate can also vary depending on your credit history; the better it is, the better the terms you will get, and your interest rate will be lower. Lenders typically consider applicants with good credit to be a low risk for their business.

The repayment period depends on the type of loan, as well as the total amount of money you are borrowing. Mortgages are typically repaid over an extended period—usually 15 to 30 years. Some personal loans are repaid in two to five years.

During this period, you pay back the loan in fixed monthly installments that include both a portion of the principal you borrowed and the interest. Fixed installments mean that your schedule and interest rate are agreed upon at the moment of signing the contract and do not change over the life of the loan.

What the Process Looks Like

When you take out an installment loan, you only borrow money once, and then you pay it back over the agreed-upon period. The process typically involves an application you submit to your lender. This is the first step. After that, your lender will probably look into your credit report, with your permission, and decide what terms you qualify for. Depending on your credit history, you may be asked for a down payment or offered various interest rates, amounts of money, etc.

In addition to the interest rate, the process of taking out a loan usually includes other costs, including the origination fee and application processing fees, as well as late fees and a potential prepayment fee. Some lenders charge this last fee if you decide to repay the entire amount of the loan before it is due. The prepayment fee helps the lender recuperate the money they lose on the interest you would have been paying.

Types of Installment Loans

As mentioned, there are different types of loans based on the terms and purposes they are taken out for. The most common reasons people take out installment loans are auto loans, mortgages, and personal loans. Auto loans are used to buy a vehicle, and their repayment period usually lasts from 12 to 60 months. In this type of loan, the vehicle is also the collateral (explained later in the article).

Mortgages are used to buy a home, and the property is the collateral. The borrower won’t own the property fully, until after the loan has been paid off. The amortization period for mortgage loans is usually long, 15 to 30 years. The most common type is the 30-year mortgage loan.

Personal loans can be used for multiple purposes. Lenders won’t always ask the applicant what they need the money for, but it must be legal. Typically, they are used to cover medical expenses, costly appliances, debt consolidation, etc.

Fixed-Rate vs. Variable-Rate Loans

In most cases, installment loans come with a fixed interest rate, which is a safe way to make sure your monthly payments will stay the same throughout the entire repayment period. Your rate is determined the day you take out the loan, and you do not have to worry about it anymore.

However, some applicants are prepared to take a risk and choose a variable interest rate. This means their interest rate depends on the market, and while it can suddenly drop, it can also become unexpectedly high. Some studies have shown that variable-rate borrowers often end up with a smaller overall loan cost. For this to happen, one must be sure that future trends will be in their favor, which can be risky if the amortization period is long.

Secured vs. Unsecured Loans

Unsecured loans are typically reserved for applicants with a very good or excellent credit score. They are also known as signature loans, as they can only require your signature as a warranty that you will honor the contract and pay back the loan on time. These loans do not require you to back them up with collateral, like secured loans. Collateral is an asset that your lender will claim if you fail to meet the deadlines of your monthly payments.

One missed or late payment does not mean the lender will immediately claim the asset. You will typically be notified multiple times before that happens. For example, if you have not made your mortgage payments even after the lender has warned you multiple times and notified you about foreclosure, they will be obligated to move forward with the process and claim your property. Although the applicant may be risking their asset, a secured loan may be a good motivator to make the payments on time. Also, secured loans can include lower interest rates compared to unsecured ones.

Interest-Only Loans

One type of installment loan allows you to skip your principal payments for a time, usually ten years at most. During this time, your monthly payments cover only the interest.

To calculate how much these payments will be, all you have to do is multiply the amount of money you owe by your interest rate, which will give you the annual total you must pay. If you divide that by 12, you can calculate your monthly payments.

After your interest-only period is over, your monthly payments will become higher, but you also have the option of making one huge payment if you can to completely pay off your loan.

The Benefits of Installment Loans

1. Easy to budget. This is a significant benefit that people who take out installment loans experience. The repayment schedule is determined upfront, which makes it easy to plan and budget your finances in advance. In most cases, these loans are also tailored to suit your needs.

2. Criteria that isn’t too strict. For those who are borrowing less money or opting for an alternative lender, the terms may be favorable even if with a less-than-stellar credit score.

3. Relatively quick access to funds. Some types of installment loans do not require a long time to be approved. When you apply for a mortgage, you may need to wait a while because the process is complex. However, when you apply for a personal loan, it is usually a matter of days until you have access to the money.

4. A positive impact on your credit score. If you take out an installment loan, and you follow the schedule by making your payments on time, it can benefit your credit score.

5. The longer the repayment period, the lower the installment. Since monthly payments also depend on the repayment period, a longer one results in lower monthly payments. Installment loans typically only take a couple of years to repay, so it is usually possible to fit an installment into your monthly budget.

6. Many lenders feature online applications. Given our hectic lifestyles, this is quite handy. Many lenders will allow you to finish at least a part of your application online, quickly and easily.

The Downsides of Installment Loans

Installment loans also have a few downsides. Entering this kind of a long-term financial agreement might be stressful because of the potential planning involved. If you suddenly lose your source of income during the repayment period, you may have issues continuing with payments.

Also, if the fluctuations of the market lead to a low interest rate, applicants who opted for a fixed-rate loan may end up paying for their loan at a significantly higher rate.

Predictable and Budget-Friendly

Installment loans are relatively easy to understand and generally budget-friendly. They are tailored to fit your needs with affordable monthly payments, but they depend on multiple factors. Typically, a fixed repayment schedule and fixed interest rate allow you to be in charge of your finances if you’ve chosen to take on this long-term financial commitment.

References:

https://www.investopedia.com/articles/personal-finance/072316/how-installment-loans-work.asp
https://www.loan.com/personal-loans/advantages-of-an-installment-loan.html
https://www.thebalance.com/interest-only-loans-315680
https://www.consumercredit.com/secured-loan-vs-unsecured-loan
https://www.investopedia.com/ask/answers/07/fixed-variable.asp
https://corporatefinanceinstitute.com/resources/knowledge/credit/installment-loan/