What is an Installment Loan?

The term “installment loan” refers to any type of consumer loan that is paid back over time on a fixed schedule. Installment loans are commonly used to consolidate other debts, build credit, or finance big purchases like houses or cars. To get a closer look at how these loans could impact your finances, we examined the most common types of installment loans, as well as alternative products for those looking solely to build credit.

Installment Loan Defined

An installment loan is a form of consumer debt that is repaid over time in regularly scheduled intervals. Banks and credit unions are the most active lenders in this category, which includes personal loans, car loans, and mortgages. While car loans and mortgages are used to finance specific purchases, personal loans can be used for a variety of purposes, including debt consolidation, building credit, or funding everyday expenses. Personal loans are easier to obtain for poor credit or low-income consumers because they can be unsecured, which means that repayment is guaranteed only by your promise to repay, and not by a physical asset like a house or car.

Personal installment loans are often confused with payday loans, which are short-term loans that are repaid as one lump sum rather than in multiple installments. Payday loans also involve smaller amounts than car loans and mortgages, and they usually carry much higher interest rates. For example, a typical two-week payday loan for $100 has a fee of $12 to $30, which translates into an annual interest rate of 390% to 780%. These same-day loans can be helpful if you are in need of emergency cash, but the high interest rates can have disastrous consequences for your financial health. If you are deciding whether you should get a payday loan, you should consider all of your other options and see if there are any feasible alternatives.

Common Types of Installment Loans

The most common types of installment loans are mortgages, car loans, and personal loans. Most mortgages and car loans require good credit and an extensive vetting process for approval, and are paid back in monthly installments over years or decades. While personal loans are easier to obtain than mortgages and auto loans, especially for low income consumers, they also tend to have higher interest rates.

Personal Installment Loans

Personal installment loans are generally used by consumers seeking to consolidate outstanding debt or pay down existing credit card debt. These loans can also be taken out to finance weddings, vacations, or other discretionary expenses. In contrast to payday loans, which are used primarily for financial emergencies, personal loans can be used as a building block towards long-term financial goals, like building credit.

For example, some consumers opt to take out personal installment loans instead of racking up credit card debt. The installment schedule and fixed interest rate on these loans can make them a more attractive form of credit than traditional credit card debt, which can grow indefinitely if left unpaid. But for consumers with poor credit, personal loans can carry interest rates from 10 to 25 percent — which can be higher than some credit card rates.

Mortgages

Home mortgages are the most popular form of long-term installment loan. Mortgages are typically borrowed in sums greater than $100,000, and are repaid with interest over the course of either 15 or 30 years. In almost all cases, borrowers seeking a mortgage need to provide a down payment that covers 3 to 20 percent of the total loan amount. Lenders will also review a mortgage applicant's financial history and credit score to determine the interest rate on the mortgage. The median interest rate for mortgages as of 2015 was 4%.

Auto Loans

Auto loans are used by consumers to finance the purchase of a new car. Like mortgages, auto loans are paid in installments over the course of years, and approval is often granted on the basis of good credit. Additionally, mortgages and car loans are both secured by collateral and a down payment. Collateralized loans guarantee that a physical asset will be forfeited to the lender if a consumer is unable or unwilling to repay their debt.

The most common term lengths for auto loan repayment are between 24 and 48 months, though 72- and 84-month plans are becoming increasingly common. While these longer loans come with lower monthly payments, they can also result in borrowers paying much more over 6 or 7 years than their car actually costs. Cars will also lose value over time, unlike most homes, so high interest rates and monthly payments on an older car can also leave a consumer paying more in debt than their car is worth — known as being "upside-down."

Installment Loans and Bad Credit

Credit scores not only influence the rate of your installment loan but may also impact your ability to receive a loan in the first place. Low credit scores can be particularly harmful when applying for larger or more costly loans. Mortgages have a stricter credit score requirement than auto loans, as houses require far larger loans than cars. For consumers with high credit scores, interest rates on 60-month loans for new cars are about 3%, while consumers with fair credit pay rates at about 7 to 10%. Applicants with poor credit receive rates 15% or higher.

Interest Rates by FICO Credit Score for Auto Loans

FICO Score36-Month Auto Loan APR60-Month Auto Loan APR
720-8503.54%3.60%
690-7194.90%4.96%
660-6896.94%7.02%
620-6599.63%9.73%
590-61913.97%14.07%
500-58915.21 %15.24%

The difference of a few percentage points, especially for longer loans, can result in spending thousands more on interest over the life of a loan. Due to the long terms of mortgages, interest rates for borrowers with poor credit are also lower than for auto loans; however, decades of paying interest on a home loan can cost hundreds of thousands of dollars.

Interest Rates by FICO Credit Score for Mortgages

FICO Score15-Year Fixed30-Year Fixed
760-8502.87%3.63%
700-7593.10%3.85%
680-6993.27%4.03%
660-6793.49%4.24%
640-6593.92%4.67%
620-6394.46%5.22%

If you are looking for a way to improve your credit score, personal installment loans can be a safe way to help you build credit. With fixed rates, these loans can be a stable, low-risk avenue for taking on and repaying debt. Financial institutions have even developed specific products that are designed to help build credit. Alternatively, secured credit cards are another option for raising your credit score. These cards require an upfront cash security deposit of a few hundred dollars, which then becomes your spending limit. Because of this cash requirement, most consumers can obtain a secured card, regardless of current credit score.

Sources

myFICO Loan Savings Calculator

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