An installment loan is a type of credit that provides the borrower with a lump sum that is later repaid through periodical and often consecutive installments. These loans amortize a portion of the principal plus interest over the full duration of the loan.
This article outlines certain key details about installment loans and how they can affect your credit score.
How Does an Installment Loan Works?
Installment loans are issued by financial institutions for a certain amount of money (the principal), and in return, the lender is compensated through the interest on the loan. The credit term of an installment loan is usually in years, but installments are usually paid monthly. A four-year installment loan will typically have 48 consecutive monthly installments (12 months x 4 years).
By definition, most loans are installment loans, and some of the most common ones include:
- Mortgages: Borrowers take out a mortgage to purchase a certain asset, such as a real estate property or machinery. In these loans, the asset involved is used as collateral to back up the loan, and their credit term is usually long. Once the borrower is approved for a mortgage, the financial institution will pay the current owner of the asset, and the borrower must pay a monthly installment to cover for the loan’s principal and interest.
- Auto loans: Auto loans are granted to individuals and companies that intend to buy a vehicle through credit. For secured loans such as these, the financial institution maintains ownership of the vehicle until all installments are paid.
- Personal loans: Personal loans are a type of consumer loan that, in most cases, doesn’t require that the borrower discloses how the funds will be used. Most personal loans work as installment loans where the borrower receives a lump sum and pays it back through a certain number of periodical and consecutive installments.
Additionally, based on whether they require collateral, installment loans can be classified as follows:
- Secured Installment Loans: Secured installment loans require collateral to be approved. This collateral reduces the risk involved in the transaction from the lender’s perspective as they can seize the asset if the borrower fails to pay their commitment on time.
- Unsecured Installment Loans: Unsecured installment loans are approved based on the borrower’s creditworthiness. They are only backed by the borrower’s promise to pay back the loan, and lenders usually require the borrower to have a solid credit history and high scores.
Advantages and Disadvantages of Installment Loans
There are various pros and cons associated with installment loans:
- Installment loans are fairly predictable since the amount of each installment is commonly disclosed at the moment the loan is approved, and for fixed-rate loans, this amount remains the same throughout the loan’s lifetime.
- Installment loans are tracked by credit reporting agencies, which means that staying current on their payments will have a positive impact on a person’s credit score.
- A variable-rate installment loan is less predictable since the amount of each installment may be increased if interest rates go up.
- Having to pay for a fixed installment each month may not be easy for someone with an unreliable income stream.
- For a secured loan, failing to pay for the installments on time may trigger the seizure or foreclosure of the collateral.
Installment Loans & Credit Scores
Installment loans are considered a credit account, same as a credit card or any other type of financing. The payment history of an installment loan is part of a person’s credit report and is tracked by credit reporting agencies.
This means that staying current on the payments of an installment loan will positively affect an individual’s credit score, and failing to pay for an installment on time will negatively affect it.
The extent of the effect that each installment loan has on a person’s credit score will ultimately depend on many factors, including:
- The total amount owed by the individual.
- The borrower’s overall payment history.
- The average age of their credit accounts.
- The composition of their credit (credit mix).
- The borrower’s credit limit and credit usage.
- The number of credit inquiries on the borrower’s report.
While it’s impossible to pinpoint the actual impact of a single installment loan, a borrower’s performance and punctual payment of these loans do affect their credit score.
Installment Loans & Bad Credit
Based on FICO’s credit scoring model, individuals with bad credit are those with a score lower than 669, as their score is below the average of U.S. consumers.
However, this doesn’t necessarily mean that individuals with bad credit have no access to funding. Some lenders may still offer certain types of installment loans to people with challenging credit situations.
Some of those types of loans include:
- Payday loans: A payday loan is issued by a lender based on a person’s proven income stream. Lenders usually require the borrower to have a paying job with a salary that is directly deposited into their bank account. Additionally, payday loans are usually extended for short periods, such as 14 or 28 days.
- Cash advances: A cash advance allows the borrower to use their credit card to get a loan. The lender basically swipes the card as if it was a regular purchase, and the amount obtained from the card is given to the borrower as a loan. The lender is compensated through interest or a future lump-sum payment that is higher than the amount given to the borrower.
- Co-signed loans: For co-signed loans, a third party serves as a backer for the loan on behalf of the borrower. The co-signer has the ultimate responsibility of fulfilling the installments associated with the loan if the original borrower fails to pay for their obligations on time.
- Title loans: A title loan works similarly to a mortgage since an asset is pledged to back the loan. This asset can be repossessed by the lender if the borrower fails to pay for the installments of the loan on time, and they are a form of secured loan.
Online Installment Loans
Online installment loans are now possible due to the rise of financial technology (fintech) companies. They have facilitated the process of applying and getting approved for one of these loans by incorporating online platforms and even artificial intelligence to increase approval speed.
The volume of online installment loans in the U.S. has grown 643% between 2014 and 2018, and they serve as a convenient tool for individuals who need funding to pay for medical expenses, pending bills, or sudden car repairs.
One of the main reasons this volume has grown is the fact that college, housing, and medical expenses have grown at a faster pace than household income. By the end of 2018, for example, household income increased 15.3% while college expenses grew more than 45%, followed by medical expenses, which grew by nearly 33%.
Finally, when it comes to installment loans, mortgages account for nearly 72% of these loans, followed by student loans and auto loans, which account for approximately 10% each.
An Example of Installment Loans
Here’s a hypothetical example of how an installment loan would work in the real world.
Let’s say Laura applies for a $5,000, fixed-rate personal loan offered by her preferred financial institution. The interest rate applied to the loan would be 12.9%, and the lender allows her to pay back the loan in three years.
This means that Laura must pay 36 installments (3 years x 12 months). Laura will have to pay a monthly installment of $168.23, and by the end of these 36 periods, she would have paid $6,056.26, which can be divided as $5,000 of principal and $1,056.26 paid as interest charges.