Your Guide to Installment Loans

Installment loans are very common, although you might not know them by this name. Traditional mortgages, car loans, personal loans, and student loans are all installment loans. You borrow an amount of money once up front and then make regular, predictable payments on a set schedule. Each payment is known as an installment (that’s why it’s called an installment loan) and each payment reduces your loan balance.

Your payments are determined using the total loan balance, an interest rate, and the time to repay the loan (also called the “term”). Most installment loans are also amortized loans, which means that early in the repayment period, more of your payment will go toward paying off interest than toward the loan principal, even though your total payment amount will remain the same throughout the life of the loan. Some installment loans have variable rates, so the interest rate can change over time, and so will your payment amount.

Installment loans can be short or long term. For example, auto and personal loans usually range from 12 to 96 months, and mortgages from 15 to 30 years. While loans with longer terms usually come with lower monthly payments, their interest rates are higher, meaning you’ll actually pay back more over the life of the loan.

Pros and Cons

Pros: Because very little changes after they’re set up (unless it has a variable-rate), installment loans are the easiest to understand and plan for. Afterall, you’ll know how much to budget each month for your loan payment and when the loan will be paid off. And you have the option of making additional or extra-large payments to pay the loan off faster.

Cons: When taking out an installment loan, you’ll need to know upfront how much you’ll need, because you can’t add on to the amount later on. Installment loans can also have fees and penalties you should be aware of—application fee (sometimes called an “origination fee”), credit check fee, and sometimes a prepayment penalty if you pay off the loan early. Not all installment loans will have these fees, so be sure to ask about them when shopping around for an installment loan like a car loan.

Installment loans and your credit score

Not only are installment loans easy to figure into your budget, but they can also help build out your credit report and raise your credit score (assuming you make all payments on time, of course!). It can lengthen your credit history, give you an opportunity to make on-time payments, and add to your mix of credit, which is weighted at about 10% of your credit score.

Words to the wise: don’t take out an installment loan just to add to your credit mix if you don’t need it or can’t afford it. First and foremost, only borrow what you can afford to pay back. Also, some installment loans could lessen your credit score, like those through rent-to-own and some retail stores, so avoid those.

Installment and payday loans

Any loans or financial products offered by payday lenders should be avoided, including enticing installment loans that are promised to boost your credit score. Even though they are advertised as available to those with little, no, or bad credit and as a solution to a cash crunch, their fees and interest rates are as bad as typical payday loans and cost just as much—putting borrowers in the same or worse financial condition than they started.

Be wary of any installment loans lasting less than a year and offered from a non-traditional financial institution. Chances are you could find a much safer and less expensive option from your local credit union.

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