What Is an Installment Loan and How Do They Work?

What Are Installment Loans and How Do They Work?

There are two types of credit: installment accounts and revolving accounts. Installment accounts are loans. You receive the money upfront and repay the loan with regular installments—hence the name. 

You may be familiar with installment loans already. Student, personal, auto, and home loans are installment loans. But let’s take a closer look at these and how they can affect your credit.

Installment loans in a nutshell

Installment loans all share several traits: 

  • You receive the loan amount upfront, and interest or fees begin accruing immediately.
  • You can't borrow more money once you accept a loan offer unless you apply for a new loan. 
  • You can often choose your repayment period and make payments on a fixed schedule.
  • Your payment amount won’t change if the loan has a fixed interest rate.

How do installment loans work?

Installment loans can work in very different ways depending on the specifics of the loan. But you always get a lump sum disbursement that you pay off with regular installments. Part of each monthly installment—or whatever the payment schedule for your loan—pays down the interest, and the rest pays down the loan’s principal balance. 

With an installment loan, the amount you accept is the total you can borrow. That’s different than a revolving credit account, such as a credit card. With a credit card, you can borrow against your line of credit, pay down the balance, and borrow again without having to reapply. 

Your eligibility for installment loans generally depends on your credit report, credit score, income, debt-to-income (DTI) ratio, and history with the lender. You might qualify for loans with favorable rates and terms if you have a good credit history filled with on-time payments and a low DTI. 

Examples of common types of installment loans

Installment loans can be secured or unsecured—a reference to whether they require collateral. 

Secured installment loans

Secured loans require collateral, which could be an asset you own or an asset you buy with the loan. If you fall behind on your payments, the lender can take the collateral to offset the unpaid balance. Although you risk losing the collateral, secured loans might offer a lower interest rate or have less stringent requirements than unsecured loans. 

Three common types of secured installment loans are: 

Mortgage loans 

A mortgage is an installment loan that you use to purchase a home. There are many types of mortgages with varying down payment, credit score, and insurance requirements. Although fixed-rate, 30-year mortgages are common, there are also mortgages with shorter repayment terms and adjustable interest rates. 

Auto loans 

Auto loans use the vehicle you buy as collateral. They generally require a down payment and can choose from different repayment periods. If you already own a vehicle, you may be able to borrow against it with an auto title loan. But these often have much higher interest rates and fees than auto loans for purchasing a vehicle. 

Secured personal loans 

Some lenders offer secured personal loans. Unlike secured loans for specific purchases, you can use the loan’s proceeds for almost anything. Generally, you’ll secure the loan by locking up funds in a savings account, brokerage account, or certificate of deposit (CD). 

Unsecured installment loans

Unsecured loans don’t require any collateral—the lender gives you the loan based on your creditworthiness. However, even if you don’t risk losing collateral, the creditor can report your late payments to the credit bureaus. Lenders can also sue you for the unpaid debt and might be able to garnish your paycheck or bank account. 

Two common types of unsecured installment loans are: 

Personal loans 

People use unsecured personal loans to finance large expenses, such as medical bills and vehicle repairs. They’re also a popular option for debt consolidation—a debt repayment strategy that involves using a low-rate loan to pay off higher-rate debts.

Student loans

Student loans are also a type of unsecured installment loan. Unlike most loans, your credit score doesn’t affect your eligibility or interest rate on federal student loans. However, your credit score is important for private student loans. 

Advantages of installment loans

Installment loans tend to be good options for large, one-time purchases because they offer:

  • Large loan amounts: Installment loans can be for thousands, sometimes millions, of dollars—especially if it’s a secured loan. 
  • Low, fixed interest rates: People who have good to excellent credit may qualify for installment loans with low interest rates. These can make them a relatively inexpensive way to finance large purchases. 
  • Choose your repayment period: You can often choose from several repayment periods based on what’s best for your budget. Longer repayment terms tend to have higher interest rates but lower monthly payments. 
  • Predictable repayment terms: If the loan has a fixed interest rate, you can easily budget because the payment amounts don’t change. Even with an adjustable or variable-rate loan, you know when the loan will be paid off. 

Disadvantages of installment loans

Installment loans aren’t always a good option because: 

  • There could be fees: Some lenders charge upfront origination fees that they take out of the loan’s proceeds. There could also be prepayment penalties if you pay off the loan early. 
  • Can’t increase the loan amount: If you want to borrow more money, you need to apply for a new loan. 
  • Can be predatory for borrowers with poor credit: Some installment loans have high interest rates and fees, which can leave borrowers stuck in a debt trap. These include payday loans, auto title loans, and high-rate installment loans.

Can you use an installment loan to build credit?

An installment loan can help you improve your credit in several ways. 

  • Your on-time payments can help your payment history. 
  • Having an open installment loan could add to your credit mix.
  • Paying down the balance can help your credit score.

However, you don’t necessarily want to apply for an installment loan and pay origination fees or interest just to build your credit. Instead, look for a credit-builder installment loan, such as Ava’s Savings Builder. One monthly subscription gives you access to both of Ava’s credit-building products—and much more. 

With the Savings Builder installment loan, you can build your savings and credit without any origination fees or interest. You can pay as little as $25 each month, and Ava reports your payments to the credit bureaus to help you build credit. After the 12-month repayment period is over, you get the entire $300 back.

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