What Is an Installment Loan and How Do They Work? A Simple Guide for Beginners

BY The Lenders Network

what are installment loans

5 minute read

If you’re looking to get a loan, you may have come across an installment loan as one of your options. What is an installment loan?

Installment loans are common loans. In fact, the average amount held by 45-54-year-olds is $14,400. That number is higher for consumers between 25-44 years old.

You might see them as mortgages, student loans, auto loans, and personal loans.

In this article we will breakdown installment loans, and dive into how they compare to other ways to get an injection of cash, and if they’re the smart financial move for you.

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What is an Installment Loan?

You know them as car loans, personal loans, and mortgages. These are all installment loans.

Installment loans are loans for any amount of money. They combine the principal and a fixed interest rate into one payment and are usually paid on a monthly basis.

For example, you might take out a $20,000 installment loan to buy a new car. With a 7% interest rate over a five-year period, your monthly payment would be $396.02 a month.

These loans are great financial tools because you can take loans out for almost any purpose. You can do home renovations, which would add to the value of your home. You can use them to consolidate debt.

Payday loans are not installment loans because they are short-term loans that must be paid in full, monthly payments are not accepted on payday loans.

How do Installment Loans Differ from Other Forms of Loans?

If you have a credit card, or credit card debt, you might think that since that’s a monthly payment, you have an installment loan.

That’s not the case, however.

What you have is called revolving credit. A line of credit is a pre-approved amount that you can draw from. You then repay the amount. As long as you stay under your approved amount, you can pay back your line of credit in monthly payments.

Some lines of credit, like credit cards, have high-interest rates. The average credit card rate in the U.S. is 16.71%.

Are Installment Loans Worth It?

Now that you know what is an installment loan, you have to ask if it’s a good option for you. When you compare it to credit cards, they can be a good option, as long as you have good credit.

Remember, installment loans are financial tools. Like any tool, it can do more harm than good if you don’t know how to use it properly.

You’re going to pay interest on your loan, and it could wind up being a bad deal for you. That’s true even if you are solving a short-term problem.

For example, let’s say that you’re getting a loan to buy a home theater system that costs $5000. Over three years at a generous interest rate of 8%, you’re going to pay $640 in interest over the life of the loan.

That $5000 system may be sweet, but it really cost $5,640.

You have to decide if that’s the best use of your money or not. If you do move ahead and get a loan, you have to be sure that it’s a smart financial move.

Otherwise, you could be throwing money at interest.

What to Consider Before Getting an Installment Loan

Installment loans are easy to get. There are two keys to getting an installment loan.

The first is your income. The second is your credit score. Here’s what else you need to think about before getting an installment loan.

Bad Credit Installment Loans

If you have poor credit you can also try your local bank, or credit union. Credit union’s are much more focused on the community than online lenders and if you are a member you will have a better chance to get approved.

Check Your Credit

Your credit score is used to determine your ability to pay back the loan. If you have a low credit score, you’ll have a higher interest rate.

Going back to the example of a $20,000 loan at 7%. Your monthly payment would be $396.02 a month. At 10%, your monthly payment would be $424.94.

Another $30 a month doesn’t seem that bad, but let’s look at the amount of interest paid over the life of the loan. You’ll pay $5496 in interest over the life of the loan at 10%. At 7%, you’ll pay about $3761 in interest.

If you do have a low credit score, there are ways to improve it, though it may take some time.

The best thing you can do is get your credit score from all three credit agencies and start working to up your score.

Your credit score will determine the interest rate you’re offered on an installment loan.

You can get a free copy of your credit report and scores online from sites like Credit Karma, and Credit Sesame.

While there are bad credit installment loans you can expect a higher rate than what is advertised.

  • Excellent credit – 720 and higher
  • Good credit 680-719
  • Fair credit 640-679
  • Bad credit 580-639
  • Very poor credit – Under 580

See if you qualify for a personal installment loan with a credit score of 580 or higher

Improve Your Score

Improving your score before applying for any type of loan is highly recommended. Here are some steps you can take to increase your credit score.

  • Make sure you stay current on all of your accounts
  • Pay down credit card balances to less than 20% of the card limit
  • No not have your credit ran too many times in a short period of time
  • Set up automatic payments to avoid late payments

More tips to improve your credit score within 30 days

Your Current Financial Situation

When you apply for a loan, you want to be sure that you can meet the monthly payments. The last thing you want to do is overextend yourself on a loan payment or default on the loan.

You should have an idea in mind as to what the purpose of the loan is. That will help guide you in terms of how much you should pay.

An installment loan for a car should be 20% of your monthly income or less. A mortgage payment should be no more than 30% of your income.

You have to look at your current expenses and your income situation. You’ll also want to look at potential ways to cut expenses or raise your income, especially if you’re going to have the installment loan for an extended period of time.

Installment Loans Can Help You in Many Financial Situations

Let’s face it, not many people have thousands of dollars in savings. Most people are living paycheck to paycheck.

What is an installment loan? It’s a useful way to get financial backing for large purchases.

That’s why these types of loans are useful. For a monthly payment, they can help you leverage your credit to achieve life goals, like buying a home, getting an education, or getting a nice car.

Before signing on, you want to make sure your financial situation is stable and your credit is in good standing. That will give you a chance to make your loan more affordable with a lower interest rate.