With an installment loan, you borrow once (up front) and repay according to a schedule. Mortgages and auto loans are typical installment loans. Your payment is calculated using a loan balance, an interest rate, and the time you have to repay the loan. These loans can be short-term loans or long-term loans, such as 30-year mortgages.
Installment loan payments are generally regular (you make the same payment every month, for example). In contrast, credit card payments can vary: you only pay if you used the card, and your required payment can vary greatly depending on how much you spent recently.
In many cases, installment loan payments are fixed, meaning they don’t change at all from month to month. That makes it easy to plan ahead as your monthly payment will always be the same. With variable-rate loans, the interest rate can change over time, so your payment will change along with the rate.
With each payment, you reduce your loan balance and pay interest costs. These costs are baked into your payment calculation when the loan is made in a process known as amortization.
Installment loans are the easiest to understand because very little changes after they’re set up, especially if you have a fixed-rate loan. You’ll know (more or less) how much to budget for each month. However, if you make extra payments (with a large lump sum, for example), you may be able to lower your payments with a recast.
Installment and Payday Loans
In recent years, installment loans have become popular with borrowers who have bad credit. These loans are offered at payday lending shops and advertised as a way to get out of a short-term cash crunch. Unfortunately, they’re often just about as expensive as payday loans.
If you’re looking at an installment loan that lasts less than a year, be careful. There’s a good chance that it’s an expensive loan, and you can probably do better with a personal loan from your bank or credit union. If you can’t qualify for a loan from a traditional bank or credit union, try an online lender or P2P loan—they’re often affordable and easier to qualify for. Ultimately an installment loan from a payday lender might be your only option, but these loans can easily lead to trouble. Watch for high-interest rates and additional products, like insurance, that you might not need.
On the bright side, some installment loans are more friendly than payday loans, even if you get the loan from a payday lending shop. Installment loans can help you build credit if your payments are reported to credit bureaus (and then you can stop using payday loan shops). What’s more, you make regular payments to pay off installment loans gradually, instead of dealing with the shock of a balloon payment.
That said, if you treat installment loans like payday loans—if you keep refinancing to extend the final repayment date—you’ll find that your debt burden only grows.
Installment Loans and Credit
Using installment loans can help your credit. A healthy mix of different types of debt tends to lead to the highest credit scores, and installment loans should be part of that mix. These loans suggest that you’re a savvy borrower; if you fund everything with credit cards you’re probably paying too much.
Don’t go crazy with installment loans; use only what you need. A home loan, a student loan, and perhaps an auto loan is sufficient. Some installment loans can hurt your credit. If you use finance companies (at rent-to-own establishments or retail stores, for example), your credit scores are likely to fall.