Installment loans: How they work and common uses
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- Installment loans cover a wide range of expenses, from homes to vacations.
- Interest can be calculated at either a fixed or a variable rate.
- Lenders will offer secured loans for larger purchases like a home or car and unsecured loans for other expenses.
- Rates are calculated based on your credit score, income and other factors.
Installment loans can be used to finance nearly every large expense. After taking out the loan, you repay the total amount — with interest — in smaller monthly installments over a set term, usually between two to 30 years.
Installment loans are different from credit cards because you receive a lump sum when you are approved. The repayment schedule is typically less flexible and has a higher minimum payment, but that comes with the benefit of knowing exactly how much you owe each month.
Chances are you’ve had an installment loan before or know someone who has. Installment loans are the most common form of financing and are offered by nearly every financial institution. Personal loans are the most popular category, but mortgages, auto loans and student loans are also common types of installment loans.
What an installment loan can be used for
Although an installment loan can cover a wide range of expenses, most are tailored to specific expenses. A lender will offer either a secured or unsecured loan based on your credit and what you plan to purchase. A home or car purchase will typically be secured, while loans for things like debt consolidation or home improvements will be unsecured.
A mortgage is a secured installment loan that uses the property as collateral. Most mortgages have 15- or 30-year repayment periods, but the way interest is calculated will depend on the type of mortgage you choose. A standard 30-year mortgage will likely have a fixed rate, while 15-year mortgages may have a fixed introductory rate followed by variable rates that may rise or fall over the course of the loan.
The term of your mortgage and how interest is calculated is based on your credit, income and other factors. Ultimately, a mortgage will be one of the bigger installment loans you encounter, with most able to fully cover the cost of a home or property purchase.
Like with any other loan, your interest rate is based on your creditworthiness and other factors like your income and current debts. And because most car loans are secured, the vehicle can be repossessed if you default on the loan. Still, they are the most common way to finance or lease a car, and you have plenty of options available when shopping for a lender.
Student loans come in two forms: private and federal. And while both options are installment loans and serve the same purpose, they have stark differences. Private student loans are offered by online lenders, banks and credit unions and often come with specific eligibility requirements that can be difficult to meet as a student.
Unlike federal loans, many private lenders don’t have a borrowing limit and can cover up to 100 percent of the total cost of attendance. However, depending on your creditworthiness, they can come with high interest rates, especially in the case of variable-rate loans.
Federal student loans are offered by the federal government and are available to every student attending an eligible post-secondary institution. The application process is streamlined through the Free Application for Federal Student Aid (FAFSA). Loan approval and rates aren’t based on your family’s finances and are fixed, meaning they remain the same until you pay off the loan. However, student loans may be either subsidized or unsubsidized, which will impact how much interest you pay.
Borrowers will often turn to personal loans when faced with an unexpected situation or crisis. Personal loans are offered by financial institutions like banks and private lenders and can be used to finance nearly any expense. However, some lenders may have restrictions on what the loan can be used for, so read the terms and conditions carefully.
But depending on the situation, you may be able to negotiate a payment plan for particularly large debts, like an emergency vet expense or a hospital bill. Check to see if there is any need-based aid available before you take on additional debt with a personal installment loan.
A debt consolidation loan is an unsecured loan that allows you to consolidate multiple lines of high-interest debt into a new personal loan with one fixed monthly payment. Borrowers often consolidate their debt to organize and streamline their monthly payments and to save money by decreasing the amount of interest paid.
It only makes sense to take out a debt consolidation loan if you’re offered a lower interest rate on your new loan than the rates of your original debts, so shop around to make sure you’re getting the best rate for your credit.
While it’s not recommended for every situation, large purchases and events can be financed with a personal loan. Vacations, weddings and big-ticket items can be financed to make the costs more manageable. There are lenders that offer purchase-specific personal loans, like jewelry or wedding loans as a way to simplify the application process for borrowers.
Buy now, pay later loans are a popular installment loan option geared toward people who need short-term payment assistance. While similar to personal loans, BNPL loans only can be used for a specific expense and typically don’t come with an APR.
While using an installment loan for a large expense or event seems like a smart way to manage the upfront cost, the interest accrual alone could end up costing more than the original expense. To save money, do your research and make sure you’ve exhausted other funding options before borrowing.
When to not use a personal installment loan
An installment loan may not be the best option for you if your financial situation isn’t stable. If you have an income that varies from month to month, ensure you can make the monthly payments in full each billing period before applying.
If you miss a payment, it will lower your credit score and remain on your credit report for up to seven years. This can make it more difficult to get approved for other purchases — like a home or car — down the road.
You also may want to rethink taking out an installment loan if you don’t need the funds urgently. If you have some time under your belt, it may make more sense to focus on saving for the expense rather than taking out a loan and paying interest.
Because there is a wide variety of installment loan configurations, you need to know the expense you want to fund before you start looking for a lender. Once that’s done, you can begin to search for lenders that fund the expense you want to make — whether that’s shopping for mortgages, auto loans, student loans or personal loans.
BY Hanneh Bareham
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