Loans

How Do Installment Loans Work?

Installment loans are some of the most popular and widely used loans out there, and odds are you’ve used one at some point in your life. The most common types of installment loans would be auto loans, mortgages, and personal loans. But what makes a loan an “installment loan” and how do these financial products really work?

Essentially, any loan that you pay off through regular payments, or “installments,” would be considered an installment loan. However, there are a lot more details to consider before taking out an installment loan. 

Read on to learn more about how these financial solutions may fit into your budget. 

Understanding Installment Loans

When you agree to borrow quick cash, 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 loan agreement. 

The amount of money you can borrow depends on several factors, like your monthly income, your credit score, and the lender’s limit. 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. It’s also important to note that a good credit score may mean a higher chance of approval, higher loan amounts, and lower interest rates. 

Your interest rate will vary depending on your credit history; the better it is, the better the terms you will get. Lenders typically consider applicants with good credit to be a low risk for their business; other applicants sometimes have to look for alternative options such as online loans for bad credit. There are many loans online, so make sure you do plenty of research before signing on the dotted line.

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

The process for an installment loan—or any loan—would begin with an application. Many applications are now offered online, but there are still some lenders that require you to fill out a paper application. 

Once the lender reviews your application they will likely check your credit history. If you’re approved, they will then provide you with the agreed upon amount. Many lenders now will even be able to directly deposit your funds into your bank account. 

As the applicant, it’s important to pay attention to the loan agreement that they offer you. Keep in mind that there are other costs associated with a loan other than the interest rate. 

Additional loan costs usually include an origination fee, application processing fee, 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 throughout the life of the loan.

Types of Installment Loans

As mentioned, there are several different types of installment loans to choose from. The one you choose will depend on your specific financial needs. The most common 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. 

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 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, or other unexpected expenses. 

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 by the lender, and will be listed in the loan agreement before you sign for the loan. 

However, some applicants are prepared to take a risk and choose a variable interest rate loan. This means their interest rate depends on the market, and while it can suddenly drop, it can also become unexpectedly high. Depending on these fluctuations, you could end up paying less overall than with a fixed-rate loan. 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

Knowing how to qualify for an unsecured loan is an important part of your research. These loans are typically reserved for applicants with a good or excellent credit score. They are also known as signature loans, as they may only require your signature as a promise that you will honor the contract and pay back the loan on time. These loans do not require you to offer up 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.

The Benefits of Installment Loans

1. Easy to budget. The repayment schedule is determined up front, which makes it easy to plan and budget in advance. In some cases, these loans are also tailored to suit your needs. Many installment lenders can allow you to set your payment date to coincide with your payday. 

2. You won’t need excellent credit. Depending on the lender and type of loan, you might be able to receive approval without having a perfect credit score. This is true most often with personal installment loans. 

3. Quick access to funds. Some types of installment loans do not require a long approval process. 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 you might receive your funds within only a day or two. 

4. A positive impact on your credit score. If your lender reports your on-time payments to the credit bureaus, your score could improve. Make sure to find out if your lender reports to any of the three major credit bureaus. 

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 can take up to 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.

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 the details will depend on your specific lender and loan. 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.

Just remember to do plenty of research no matter what type of loan you’re considering. Ask questions, read online reviews, and thoroughly review the terms and conditions of the loan agreement. These measures will ensure that you get the loan that you need, with the terms that you deserve.

References:
How Installment Loans Work | Investopedia
Interest Only Loans | The Balance
Secured Loan vs. Unsecured Loan | Consumer Credit
Fixed and Variable Rate Loans: Which is Better? | Investopedia