What Is an Installment Loan? How It Works and Why It Matters

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An installment loan is a loan you repay over time in equal payments, usually on a monthly basis. Each payment includes a part of the loan principal, which is the original amount of money you borrowed from a lender, and interest.

Installment loans are common for borrowing larger sums of money, to pay off or consolidate debt. They’re different from payday loans and revolving loans, which are for smaller amounts of money and have a specified credit limit, respectively.

How Do Installment Loans Work? 

If you’re thinking of getting a personal loan, it may very well end up being an installment loan. Installment loans work by letting you borrow a set amount of money that you then pay back over time in regular monthly payments via installments.

In addition to repaying the amount you borrowed, you’ll pay interest. The exact amount of interest you pay, expressed as a percentage, will depend on your credit score and other financial factors you share with the lender when you apply.

One of the benefits of an installment loan is that you have predictable payments that stay the same every month, and you know exactly how long it will take for the loan to be paid off. This theoretically makes an installment loan easy to work into your budget.

Types of Installment Loans 

Various types of loans fall under the installment loan category. Here’s a detailed breakdown.

Auto Loans 

Car loans are considered installment loans. With an auto loan, you generally make a down payment toward the total cost of the car, and then pay off the remainder of the cost plus interest on a monthly basis.

Auto loans are considered secured loans because the car serves as collateral if you’re not able to repay the lender.

Mortgages 

Mortgages are another common type of installment loan. When you borrow money to purchase a home, you generally pay the funds back over a longer term, such as 15 or 30 years. Your monthly mortgage payment will include repayment of the original funds you borrowed as well as interest on that money.

One variable to keep in mind with mortgages is that you can get either a fixed-rate or adjustable-rate home loan. With a fixed-rate mortgage, your interest payment remains the same over the entire repayment term, meaning you have predictable monthly payments.

With an adjustable-rate mortgage (ARM), however, your interest can rise or fall based on an interest rate index and a margin added by the lender. ARMs often start with lower interest rates compared to fixed-rate mortgages, but there’s the risk that rates can go higher over time.

Personal Loans 

Personal loans can be used for almost anything, from home improvement projects to paying for a wedding to consolidating debt. They usually don’t require any collateral, and they’re considered installment loans because you pay them back in equal monthly installments.

As with the other types of loans mentioned here, make sure you’re familiar with the pros and cons of a personal loan before taking one out. They can be used for many different expenses and offer predictable monthly payments, but they can be expensive if you don’t have a strong credit score and can negatively impact your credit profile if you fail to make payments on time.

Student Loans 

Student loans, used to pay for the substantial expense of college tuition, are another common flavor of installment loan. Student loans are considered unsecured debt, with no collateral required.

Since many students don’t make an income while in school, many student loans offer a grace period after graduation, meaning you don’t have to start repayment until you’ve graduated and hopefully secured a job.

Installment Loan Example 

Here’s an example to demonstrate how an installment loan works.

Say you borrow $5,000 for an auto loan with a 6% interest rate for 24 months. Each month, you’ll pay the same amount until the loan is fully repaid.

This is how your payments would break down in the first year versus the second year. As you can see, you’ll be paying more in interest in Year 1 and more toward the auto loan principal in Year 2.

Benefits of Installment Loans 

No matter which type of installment loan you’re considering, make sure you’re aware of the advantages and disadvantages before you apply or sign any paperwork.

Pros: 

• Fixed monthly payments (easy to budget) 
• Lower interest rates than payday loans 
• Can help build credit if paid on time 

Cons: 

• May include fees or penalties for early repayment 
• Not as flexible as a credit line 
• Can negatively impact your credit if you don’t make on-time payments

Installment Loans vs. Other Loan Types 

Installment loans are defined by their fixed, regular monthly payments, whether you’re paying off a mortgage, auto loan, student loan or personal loan.

Other types of loans work differently. For instance, with payday loans, you’re generally borrowing a smaller amount of money that you need to pay back in one lump sum by your next paycheck.

Revolving credit loans are also different. With these, such as a home equity line of credit (HELOC), you can borrow up to a certain set credit limit during a specified draw period, and you can borrow and repay funds throughout that timeframe.

Essentially, installment loans offer predictable payments, while other types of loans may require lump sum payments or have repayment terms that depend on how much you borrow against a line of credit.

Is an Installment Loan Right for You? 

An installment loan could be a good option if: 

• You need to borrow a set amount and want predictable payments.
• You’re comfortable with a longer-term commitment, especially if you’re looking for a mortgage or student loan.

However, it may not be a good fit for you if:

• You need a small, quick loan you’ll repay fast. In this case, you’d pay too much in interest by spreading your repayments over a longer period of time.
• You don’t want to risk fees or interest buildup.

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