What Is Installment Credit, and How Can It Help Your Finances?
Understanding installment credit and how to use it may be essential for your financial journey.
September 26, 2022
Life’s major purchases often require more cash than the average person has. From a house to a car, most of us can’t afford the purchase in a single installment.
That’s where borrowing money from lenders in the form of revolving credit or installment credit comes in. Installment credit can make major purchases easier, but it has caveats and considerations.
What is installment credit, and how does it 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.
Installment loans are consistent; you can expect to pay the same amount monthly. In rare cases, such as a mortgage, the interest rate of an installment loan can be variable. If your interest changes during your loan, your monthly payment may go up or down.
Installment credit can be issued in months or years, depending on the loan amount and the terms of the loan. The interest rate typically depends on your credit and the length of the loan. Longer loan terms are usually paired with higher interest rates, though they offer lower monthly payments thanks to a lengthier repayment period.
Here’s an example of how a simple installment loan works.
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, due on the 15th of every month.
After making your 24th loan payment, you will have paid $5,318.47 to borrow $5,000. The additional $318.47 is interest.
If you’re considering an installment loan, a simple loan calculator can help you estimate your monthly payments based on the amount of money you need to borrow, your interest rate and the repayment period.
Common types of installment loans
Installment loans are typically used for large purchases you can’t pay with cash or may exceed your credit card's credit limit. The following are examples of installment loans you will most likely encounter.
Mortgage loans are commonly issued over 15- or 30-year periods, with a higher interest rate for longer loan terms. Another popular mortgage installment loan is the five-year adjustable-rate mortgage (ARM), in which the interest rate can change after five years.
A larger initial down payment on a house can help lower your interest rate and monthly payment.
Student loans are installment loans issued federally or privately to cover education expenses. Typically, students have 10 years (sometimes longer) to pay back federal student loans. Interest rates and loan terms vary if the installment loan is acquired privately.
Car loans are, on average, much shorter than mortgages or student loans. Installments are usually paid anywhere from 12 to 84 months. Like a mortgage, the interest is generally higher if your loan term is longer. A longer loan leads to a lower monthly payment, but you pay more for your vehicle when you account for the total interest paid.
Most personal loans also fall into the installment loan category. Depending on the borrower and the terms of repayment, personal loans can have a wide range of interest rates (from 3% to 36% as of August 2022). Online loans available to those that need money urgently have become increasingly popular, but they can come with a hefty price tag and an assortment of hidden fees.
Payday loans are technically a type of installment loan, though they operate a bit differently. These loans usually don’t require a credit check and are for much smaller amounts (typically under $1,000). They have high interest rates and a short repayment term. Usually, the entire loan amount is due as a lump sum after your next payday. These loans are generally only used in emergencies and are best avoided whenever possible.
Advantages of installment credit
Installment loans offer several distinct advantages compared to lines of credit and other revolving credit accounts.
With revolving credit, the amount of money you owe can change monthly. On the other hand, installation 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 changes at certain times during your loan term. But overall, if you’re using installment credit, you know the exact amount you can expect to pay each month and for how long. A predictable payment schedule makes it easier to manage your personal finances.
Lower interest rates
When compared to 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 lower rates than revolving credit. But when it comes to personal loans or payday loans, interest rates may equal or surpass those of revolving credit.
Larger loan balance
Installment credit allows you to borrow much more money to finance major expenses like a home or automobile. For many, an installment loan is the only way to afford these purchases.
Disadvantages of installment credit
Of course, installment credit isn’t perfect for everyone. Here are some potential disadvantages to be aware of when comparing the types of credit available to you.
On average, getting your hands on an installment loan can be more difficult than getting approved for a credit card. Lenders pay close attention to your FICO credit score, with factors like your payment history playing a big role in determining interest rate and approval. If you have bad credit, you may 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. If you want to pay off your loan faster to avoid interest, these prepayment fees may wash out your extra payments. Research prospective lenders and prepayment terms before entering into an installment agreement.
Most installment loans have additional fees added to the total sum of money you owe as part of your loan. For example, origination fees are charged when you set up a new loan agreement. Fees increase the total amount you owe, potentially making them more expensive than a revolving credit account for smaller loan amounts.
How installment credit affects your credit score
Installment credit plays a role in your credit score. If you make every installment loan payment on time, you’re likely to see your score tick up over the loan period. On the other hand, late payments are reported to credit bureaus and may hurt credit history.
Like closing a credit card account, your score can drop after paying off and closing an installment loan. This is because it affects your credit mix by reducing the variety of open accounts you have that are in good standing.
You may think 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.
Your score should only drop a few points after you repay your loan. Over time, having that account paid off can increase your credit score by helping improve your debt-to-income ratio.
Pay off installment loans early to avoid interest
While paying off debt earlier may not affect your credit score positively, it can help you avoid interest. Just make sure your lender doesn’t charge prepayment penalties.
Here’s an example of how this would work with a mortgage:
You have a 30-year mortgage. borrowing $100,000 at a 4% interest rate. If you pay the fixed monthly installment, at the end of the 30 years, you will have paid $171,869.51 — almost double the amount you borrowed.
But if you add $100 to your monthly mortgage, you’d shave about eight years off your loan and only pay $49,405 in interest payments.
Another way to pay off your mortgage early and save on interest is to use your tax refunds to make extra payments.
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 $53,000. That’s nearly $20,000 of extra money you get to keep.
Use installment credit wisely
No two people have the same financial situation, but by:
Researching potential creditors for hidden fees and prepayment penalties
Trying to lock in the lowest interest rate possible before you sign for an installment loan
You can get a loan that works best for you.
Remember, you can opt for shorter loan terms to avoid higher interest rates and look for ways to boost your credit score before obtaining an installment loan. This can help you get more favorable loan terms and save money in the long run.
If credit card debt is weighing on you, check out the Tally† credit card payoff app. By combining your credit card debt into one easy payment, you can reduce debt more efficiently and improve credit scoring factors.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.