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Whether you’re trying to improve your credit or looking at a large purchase, chances are you’re hearing about installment loans. These types of loans are very common and can help you afford more expensive items over time and improve your credit if handled correctly.
Let’s get into what installment loans are, how they work and how they can affect your credit.
What is an installment loan?
An installment loan is a loan that breaks up the payments over a specific period of time. The payments are also the same amount throughout the term of the loan. Installment loans are different from revolving debt, such as credit cards, because the loan is for one lump sum and is paid out every month over time in installments.
For example, if you get a personal loan for $10,000 for house repairs, you pay the $10,000 off in smaller payments every month until the balance is zero.
With revolving credit, you can keep accessing the same amount of credit as you pay it off. So if, for example, you have a credit card with a $10,000 limit and charge $5,000, once you pay off the $5,000, you have access to the full $10,000 again.
Examples of installment loans
An installment loan is any type of loan that’s being paid off over time from a starting balance to a balance of zero. Common examples of installment loans are:
- Auto loans: These loans help you finance the purchase of a vehicle over time.
- Mortgage loans: A mortgage loan is the type of loan required to purchase a house.
- Personal loans: These loans can be taken out to pay for a variety of expenses, such as debt consolidation, renovations and large purchases other than a vehicle or home.
- Student loans: Students loans can be private or government-sponsored and are used to pay for tuition, books and other expenses associated with college.
Installment loan terms differ depending on the type of loan. Term lengths can be very short, such as two or three years in the case of vehicle or personal loans, but can go all the way up to 30 years for a traditional mortgage. Interest rates also vary widely by type of loan and your personal credit history.
Another thing to be aware of is whether a loan is secured or unsecured. Secured loans have some type of collateral, such as with home and auto loans.
Student loans and personal loans are unsecured because there’s nothing the lender can take back to recoup their money if you don’t pay. This usually means unsecured loans have higher interest rates or lower borrowing limits as well.
Does an installment loan help credit?
An installment loan can help your credit in most situations. The key is that you want to be sure you make your payments on time every month and in full to help build positive credit history. However, there are some factors involved in getting an installment loan that could hurt your credit in the short term.
An installment loan increases your overall debt, which can change your credit utilization ratio. It also decreases the average age of your credit, and it will add a hard inquiry—which is what happens when a potential lender checks your credit.
In most cases, if you pay the loan as agreed, these initial hits are minimal and will be outweighed by the credit building over time, but they’re something to keep in mind if your credit is borderline and you’re only getting an installment loan to try to increase your credit score.
What happens when you pay off an installment loan?
While it may seem like a good thing to pay off your installment loan, you might be surprised that it can have a negative impact on your credit in the short term. This is because it can decrease your credit mix if it was your only installment loan, and it counts as closing an active account.
However, it also decreases your credit utilization and overall amount of debt, which is good for your long-term credit. So you may notice a small dip in your credit when you pay off your installment loan, but it should recover over the next few months.
Pros of installment loans
Some of the pros of getting an installment loan are:
- There are a lot of different options out there. Installment loans are common, with many financial institutions offering multiple types and terms, so you can comparison shop and find the best rate and terms for your situation.
- It can help you build credit over time. As long as you make your payments on time and in full, an installment loan should have an overall positive effect on your credit.
- The terms are consistent throughout the loan. Whatever terms you agree on at the beginning of the loan, such as interest rate and payment amount, will stay the same for the life of the loan, so there are no surprises.
- You may find lower interest rates. Interest rates on installment loans vary widely, but overall, they are usually lower than what you might qualify for with the same credit score on a revolving credit line, such as a credit card.
- You can save money by paying the loan off early. Installment loans can be paid off early, which can save you a lot of money in interest. However, some banks charge a prepayment penalty to help them recoup that missed interest, so make sure to ask about that before signing.
- Installment loans make it easier to afford large purchases. While it’s possible to gradually save up for a car or a house, it can take a very long time and in many cases just isn’t practical. An installment loan lets you move forward in life without spending years or even decades saving cash.
- You can refinance later on to save money. If your credit improves or interest rates drop, it’s possible to refinance an installment loan at any point for better terms. Again, just make sure you’re aware of any prepayment penalties that may apply.
Cons of installment loans
While installment loans are usually fairly straightforward, there are some potential pitfalls to be aware of:
- You might borrow more or less than you need. With many installment loans, especially unsecured ones, you’re the one making the request for the loan amount. This means you may end up borrowing more than you need—and paying more interest over time—or end up with not quite enough money for whatever your goals were.
- It can hurt your credit. Upping your debt amount, decreasing the age of your credit and adding a hard inquiry can temporarily bring your credit score down.
- Your loan terms are directly related to your credit. This is good news if you have great credit, but if you’re working with poor or fair credit, this could mean higher interest rates that could cost you serious money over the life of the loan.
- There may be other fees. Some loans charge you a fee—usually a percentage of the principal—if you pay the loan off early, and there may be other charges to be aware of such as late payment penalties and fees.
- You’re locked into the payment for the life of the loan. Because you’re agreeing to pay the same amount over many months or years, you’ll need to make sure the amount fits in your budget now and in the future, based on what you expect to happen.
- You can face repossession. For secured loans, you can lose your collateral if you don’t pay according to the terms. This means if you financed a car, camper or even house through an installment loan and quit paying, the bank can repossess it to get the value back out of their investment.
Installment loans for bad credit
It’s possible to get an installment loan even if you have fair or poor credit, but you’re going to end up with less favorable terms. To get the best rates, check with credit unions and online lenders to see if you can prequalify so you know what your terms might be without racking up hard inquiries on your credit.
You may also want to consider getting a cosigner, which can help you get more favorable terms if the cosigner has better credit.
Is an installment loan the best choice for you?
Whether an installment loan is the best choice for your situation depends on the particulars. If you need to finance a new purchase such as a car and can afford the payments, it can help you get what you need now and build credit over time.
However, it’s important not to overextend yourself because missed payments or a repo can bring your credit down even further.
