In a perfect world, we would all have enough money to cover all of our expenses and major purchases upfront. I don’t know about you, but unfortunately, that’s not the world I live in.
Although I am fairly financially savvy, installment loans are still a part of my money strategy. After all, like most people, I didn’t have enough money to fund my largest purchase yet – my first home – without taking out an installment loan.
If you are in the same boat as me and unable to cover a major purchase of your own, then it might be time to consider an installment loan. But what is an installment loan, and how does it work?
Luckily for you, I’ll cover everything you need to know below.
What is an installment loan?
An installment loan is simply a lump sum amount of funds that you can use to make a purchase. After you take out the loan, you’ll need to make regular payments over the loan term to repay it.
The regular payments are called “installments.” Hence the term “installment loans.”
How does an installment loan work?
When you are approved for an installment loan, you’ll receive a lump sum payment upfront. In some cases, you’ll receive the cash to spend as you wish. In other cases, the lender may send the funds directly to cover the purchase.
After the funds are dispersed, you will be required to make payments at regular intervals in set amounts. The regular payments will include the principal you owe on the loan, plus the interest payments. In most cases, you’ll make monthly payments, but the payment schedule can vary based on the lender.
The regular payments will continue for the duration of your loan term. The loan term is the amount of time that you agreed to when you signed the loan documents. For example, you might have a loan term of 12 months for a small personal loan or 30 years for a home purchase.
Installment loans vs. revolving credit options
The two major types of borrowing options are installment loans and revolving credit.
Like I’ve discussed, installment loans are attached to set loan terms. After you receive the upfront loan, you’ll make regular payments for the duration of the loan term. The payment amount will not fluctuate over time.
Unlike an installment loan, revolving credit is associated with an open line of credit. You’ll be able to make charges against the credit at any point, up to a specified credit limit. With that, you will find that the monthly payments vary dramatically and can be difficult to budget for. However, you’ll have the convenient ability to borrow more when you need it.
A great example of a revolving credit option is a credit card. You can open a credit card and receive a credit limit. You’ll be able to make charges throughout the month, but when your bill comes, the total amount due will vary based on your charges made that month.
Secured vs. unsecured installment loans
Installment loans come in the form of both secured and unsecured loans.
Unsecured installment loans do not require collateral of any kind. With that, you will not be required to attach any of your assets to the loan. However, the lack of collateral can make these loans more difficult to qualify for.
Secured installment loans include mortgages and auto loans. A secured loan requires that you put up an asset as collateral for the loan, which the lender has the right to take if you default on the loan.
In general, secured installment loans will have better interest rates available. But unsecured installment loans come without the risk of losing an important asset, like your home or vehicle.
What can installment loans be used for?
With that, you can use an installment loan for many different types of purchases. For example, a personal loan can be used to consolidate debt, upgrade your home, pay for a wedding, cover an unexpected medical bill, and more.
Pros and cons of installment loans
As with every financial product, there are some advantages and disadvantages to keep in mind as you consider installment loans.
Pros of installment loans
- Predictable payments. A regular payment can be easier to budget for and you won’t have to worry about a surprise bill along the way.
- Finance a major purchase. Most of us can’t afford to fund a major purchase in cash. An installment loan can help you make the purchase and commit to an affordable payment plan.
- Possibility to pay off the loan early. If you are able to, then you could save money on interest payments by paying off the loan early. Keep an eye out for early prepayment penalties if this is an option you want.
- Potential to build your credit score. If you can make on-time monthly payments for the course of the loan, your credit score might improve.
Cons of installment loans
- Potential to overborrow. An installment loan is disbursed at one time. You’ll need to know exactly how much you need upfront or risk overpaying.
- Potential to damage your credit score. If you miss payments, then you could hurt your credit score.
- May have high interest rates. If you have bad credit, you may struggle to find a loan with low interest rates.
- Sneaky loan fees. Watch out for origination fees and prepayment penalties that could increase the overall cost of your loan.
Who should (and shouldn’t) use installment loans?
Who should use installment loans?
If you have a good credit score and a reliable income, then an installment loan could be a good fit for you.
Even though you may not have the savings to cover a major purchase, your good credit score can help you get an attractive interest rate on your loan. Plus, if you have a reliable income, then you can confidently commit to your regular payments.
Who shouldn’t you use an installment loan?
If you have bad credit or an unreliable income, an installment loan is probably not the right fit for you.
Unfortunately, a bad credit score will likely mean a higher interest rate for your loan. Those interest payments can add up quickly and make it difficult to keep on top of monthly payments! Instead of trying to get an installment loan now, take some time to boost your credit score. The effort could save you big time!
If you don’t have a reliable income, then an installment loan might not be a good fit. The regular payments could become a burden if you aren’t sure what next month’s income will bring. With that, you may want to hold off until you have built a strong emergency fund to ensure you can cover the costs even with a bad-income month.
What to look for in an installment loan
Have you decided that an installment loan is the right choice for your situation? It’s important to shop around for the best deal before you commit to a lender. Here’s what you should look for in your search:
- APR. The APR attached to an installment loan is a critical factor. A lower APR will help you minimize the costs of the loan.
- Fees. Most lenders will have fees associated with their installment loans. Take these fees into account as you determine the best loan option for you and how it will fit into your budget.
- Loan terms. How long do you want to make payments on this loan?
- Autopay. Lenders that offer autopay options can help you save money due to fees charged for missed payments. If you want to set it and forget it, then check that the lender offers this option.
An installment loan can help you cover the costs of a major purchase. Although the details of each loan will vary, you will be able to make set payments on a regular schedule. That’s a lifesaver for any budget!
Take the time to shop around for the right lender to ensure the lowest costs and necessary features for your situation.