As kids, we all borrowed lunch money from our parents (and probably never paid them back). But as adults, the training wheels are gone.
But now, the name of the game is building and maintaining credit. And sometimes that requires borrowing hefty amounts of cash for major life purchases, which definitely needs to be paid back). We’ve graduated to borrowing money from lending institutions in the form of revolving credit or installment credit.
Let’s take a closer look at how installment credit works and determine if it’s right for you.
How does installment credit work?
Installment credit is a structured loan in which money is lent with fixed terms, monthly payments and interest. With most types of installment credit, you make fixed payments until the loan is fully paid off.
The essence of an installment loan is consistency. You can expect to pay the same amount on the same date every month. In rare cases, such as a mortgage on a house, the interest rate of an installment loan can be variable. If your interest changes during the course of your loan, your monthly payment may go up or down.
Installment credit can be issued in a period of months or years, depending on the loan amount. The interest rate on your loan typically depends on your credit and the length of the loan. Longer loan terms are usually paired with higher interest rates.
Here’s an example of a simple installment loan:
You need a $5,000 loan for home repairs. Your loan comes with a 6% interest rate and an installment period of 24 months. That means your fixed monthly payment is $221.60, and it’s due on the 15th of every month.
After making your 24th loan payment, you will have paid $5,318.57 to borrow $5,000. The additional $318.57 is what you paid in interest.
Determine your payments with this simple calculator and continue on for different types of installment loans.
Common types of installment loans
Mortgages are a popular type of installment loan. Mortgage loans are commonly are commonly issued over 15- or 30-year periods, and the interest rate typically climbs the longer the loan term. Another popular installment loan for mortgages is the 5-year adjustable-rate mortgage (ARM), in which the interest rate can change after 5 years.
Student loans are installment loans that can be issued federally or privately. Typically, students have 10 years (sometimes longer) to pay back federal student loans. If the installment loan is acquired privately, interest rates and loan terms can vary greatly.
Auto installment loans are, on average, much shorter than mortgages or student loans. Installments are usually paid anywhere from 12 to 96 months. And like a mortgage, the interest is usually higher if your loan term is longer. A longer loan works out to a lower monthly payment, but when you account for total interest paid, you end up paying more money for your vehicle.
Most personal loans also fall into the installment loan category. Depending on the borrower and the terms of repayment, personal loans can have higher interest rates than mortgages or auto loans. Online loans available to those that need money urgently have become increasingly popular, but they come with a hefty price tag and an assortment of hidden fees.
Advantages of installment credit
Unlike revolving credit, where your minimum can adjust every month, installment payments are fixed and allow you to budget appropriately. If your installment credit comes with a variable interest rate, there is a potential to see slight changes at certain times during your loan term. But overall, if you’re paying installments loans, you know the exact number you can expect to pay each month.
Lower interest rates
When comparing interest rates of credit cards, installment loans are usually a more frugal approach to borrowing money. Depending on the type of loan, installment loans are more likely to offer much lower rates than revolving credit. But when it comes to personal loans or payday installment loans, interest rates can equal or surpass those of revolving credit.
Installment loans can be obtained rather quickly, and it doesn’t take long to get cash. Some loans can get approved in as quickly as 24 hours, and the process normally doesn’t take longer than two weeks.
Disadvantages of installment credit
On average, getting your hands on an installment loan can be more difficult than getting approved for a credit card. Qualified borrowers, rejoice! But if you have questionable credit, you may have to face a disappointing disapproval notice.
Some lenders do not allow you to make payments larger than your fixed monthly payment. And those who do may charge a sizable prepayment fee. So, when you want to pay your loan down faster to avoid interest, your extra payments may be washed out by prepayment fees. It’s always best to thoroughly research prospective lenders and their prepayment terms before entering into an installment agreement.
If your loan term is longer (which means lower monthly payments), your interest rate will be higher. Loans with shorter terms have attractive interest rates, but for the average person, the monthly payment is unfeasible.
How installment credit affects your credit score
Installment credit plays a big role in your credit score. If you make every payment of your installment loan on time, you’re likely to see your score tick up over the period of your loan.
Unlike closing a credit card account, once an installment account is closed out with a final payment, you’ll probably see a satisfying boost to your credit score.
But if you close a credit card account, your score can plummet.
You may think that paying down your installment loan quicker will get you a better score, but that’s not necessarily true. More or larger payments won’t necessarily have a greater impact on your score than making your regular payments, but once the account is paid in full, you should see a positive nudge.
Pay off installment loans early to avoid interest
While paying off debt earlier won’t affect your credit score positively, paying off a loan early is never a bad thing to do — especially when it comes to avoiding interest. Here’s how you can do it with a mortgage:
You have a 30-year mortgage. You borrowed $100,000 at a 4% interest rate. If you pay your fixed monthly installment, at the end of the 30 years you will have paid $171,869.51 — almost double the amount of what you borrowed!
But if you add $100 to your monthly mortgage payment, you’d shave eight years off your loan and would only pay $49,405 in interest payments.
Another interest-smashing option is using your tax refund.
Using the example above, if you get a $1,000 tax refund and put that extra amount toward your mortgage every April, you’d whittle your interest down to approximately $52,000. That’s nearly $20,000 of extra money you get to keep.
Recap of installment credit
We covered a lot. These are the key things to know before you enter into an installment loan:
- Research your potential creditors for hidden fees and prepayment penalties.
- Try to lock in the lowest interest rate possible before you sign for an installment loan.
- If you can, opt for shorter loan terms to avoid higher interest rates.
- Look for ways to boost your credit score before obtaining an installment loan.