What is an installment loan?

How does an installment loan work?

With an installment loan, you borrow a specific amount of money, receive it all at once and pay it back in regular payments, or installments, over the loan’s repayment term.

Most installment loans have a fixed principal and interest (P&I) payment structure, while others have a principal plus interest (P+I) payment structure.

Fixed principal and interest (P&I) payments

With this structure, your regular payment amount never changes, but the amount of that payment applied to principal and interest varies. The P&I payment is determined using an amortization schedule that calculates how much principal you must pay each period to repay the loan in full.

For example, let’s say you borrow $2,400 with an interest rate of 6% and a six-month repayment term. As shown below, your monthly payment of $407.03 won’t change. However, because it’s a P&I payment, the principal portion of the payment will increase and the interest portion will decrease over time.

Principal plus interest (P+I) payments

While P&I payments are the most common structure, some installment loans use a principal plus interest (P+I) payment structure instead. With P+I payments, the amount of principal you pay each period never changes and is evenly divided over the loan’s term. However, the total payment will change as the interest owed for each period varies.

In the same example as before, the P+I payment breakdown over the life of the installment loan is shown below. The principal portion of the payment never changes, but the amount of interest and total payment change each payment period.

While the interest rate was fixed in our P+I example, lenders often use P+I payments for loans with variable interest rates. The reason is that this type of payment structure is designed to allow for the interest charges to change each payment period, something that often occurs with a variable rate.

» MORE: Interest rates and how they work

How to get an installment loan

To get an installment loan, you'll fill out an application with a lender or a marketplace that offers access to multiple lenders. The application will require basic information about your identity, income and credit status. You can get installment loans from banks, credit unions and even online lenders.

Before officially applying, here are some factors to consider when looking for an installment loan:

• Credit check: Read the fine print to understand if the lender will perform a soft or hard pull on your credit. A soft pull gives the lender a snapshot of your credit and doesn't affect your score, while a hard pull happens after you formally apply. Hard pulls typically lower your score by a few points.
• Rates and terms: Some lenders will allow you to prequalify for their loans by submitting your basic financial details. A lender will assess your candidacy by doing a soft pull on your credit. Prequalifying will reveal the approximate loan amount, interest rate and repayment term you’ll likely be approved for with a lender if you decide to officially apply. You can use the prequalification details to compare multiple lenders.
• Approval odds: While approval criteria vary by lender, you generally must demonstrate willingness and ability to repay the loan. Credit scores indicate your willingness to repay, and income shows your ability to repay. For most installment loans, you’ll need a credit score of at least 580 to 620 and a debt-to-income ratio of 43% to 50% or less.
• Funds distribution: If you like the terms offered, you can sign the paperwork (in person or electronically) and receive funding. Depending on the loan you get and the lender you use, the funds might be deposited into your bank account directly or sent to a third party.

As you’re shopping for an installment loan, take time to research the available options. Lakhbir Lamba, head of consumer lending at PNC Bank, said you should make sure to “evaluate the interest rate, repayment term, fixed monthly payment and any fees. Compare these from multiple credible lenders and don’t forget to read the fine print."

Reading the fine print is an important step, as this is where you may find differences between installment loans. For example, if your goal is to pay the loan off faster than scheduled, ensure the loan doesn’t include a prepayment penalty.

Types of installment loans

Many of the loans you’re already familiar with — mortgages, personal loans, auto loans, etc. — are common installment loans. These loan types wouldn’t be realistic for many borrowers without the option to repay in installments.

Pros and cons of installment loans

Installment loans have a lot of upsides, especially for those with higher credit scores. But they can easily be mismanaged.

Since installment loan types and terms vary widely, “consumers should also consider their financial goals, credit history and overall financial health to ensure they choose a financing option that aligns with their unique circumstances and contributes positively to their long-term financial well-being,” recommended John Owens, executive vice president of Monterey Financial Services in Oceanside, California.

Alternatives to installment loans

While installment loans make budgeting easy since you repay a consistent amount each period, they’re not always the right option. For instance, if you want the option to make a lower payment or anticipate needing to borrow repeatedly, you might consider a line of credit or credit card.

Gates Little, president and CEO of The Southern Bank in Alabama, says a downside of an installment loan is that there’s no option to make a lower minimum payment; rather, your payment never changes. Little explained that if you lose your income, “that regular monthly payment can feel less affordable and may be harder to make.”

So, before you get an installment loan, always make sure you can afford the payment. If you want payment flexibility, credit cards or lines of credit often only require a minimum payment, but they may carry higher interest rates.

Credit cards

Credit cards are preferable to installment loans if you’d like to repeatedly borrow money and plan to repay the money very quickly (e.g., within a month).

If you can’t repay the borrowed money quickly, you’ll likely pay less interest with an installment loan, as installment loans often have much lower interest rates than credit cards.

Budgeting for installment loans is also easier since their payments and interest rates are usually fixed. Credit card interest rates are usually variable, so your interest costs increase in a rising interest rate environment.

Revolving lines of credit

A line of credit is similar to a credit card in that you can borrow money and repay it over and over again. This type of financing works well when you want to be able to access funds more than once.

If you have a lot of equity in your home, you might consider getting a home equity line of credit (HELOC). With this type of line of credit, your home is offered as collateral, so you can typically get better rates with a HELOC than with an unsecured line of credit. Plus, you might be able to borrow more money.

Many HELOCs have two distinct periods. During the draw period, you can borrow and repay the money as often as you want. During the repayment period, you can no longer borrow money. A draw period typically lasts 10 years, and the repayment period might be an additional 10 to 20 years.

Bottom line

Taking out an installment loan is a common way to borrow money to cover a big expense. You get a lump sum of cash and pay it back in regular installments. Many installment loans have fixed interest rates with equal monthly payments, which makes budgeting and planning easy.

If you’re considering an installment loan, compare offers from various lenders, including your local bank or credit union and online companies, to find the loan with the lowest cost that you’ll qualify for. Ensure you understand all the loan terms, like the APR, the monthly payment, the number of payments, the late fee amount and whether there is a prepayment penalty.