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What Is an Installment Loan and How Do They Work?

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Consumers interested in borrowing money to meet their financial needs may want to consider an installment loan. This type of loan requires a fixed monthly payment throughout the term, which could make it easy to calculate into a budget.

But before taking out an installment loan, you’ll need to know the basics, from the pros and cons of taking one out to how to qualify.

What is an installment loan?

An installment loan is a loan that combines the principal loan amount with an interest rate. That total is then scheduled to be paid back in equal amounts over a set time frame. Typically, these loans are repaid monthly and may require some form of collateral.

Several variables determine an installment loan’s monthly payment. Notably, your credit score affects the interest rate you receive. The better your score, the better your rate may be. The amount you borrow and the loan term are also factors that affect repayment.

The four most common types of installment loans are:

Although there are many types of consumer and business installment loans, we will focus on personal loans.

Risky installment loans vs. legitimate installment loans

Payday or vehicle title loans may be considered installment loans. But payday and vehicle title loans tend to have short repayment terms, typically 30 days or less. Traditional installment loans, such as personal loans, generally have longer repayment terms. Our personal loan marketplace shows lenders offering terms from 12 to 84 months.

But payday loans and auto title loans are considered risky when compared to other types of loan products. The Consumer Financial Protection Bureau reports that default rates on vehicle title and payday installment loans are high, with online payday installment loans listed as the highest. The bureau also points out that borrowers with a greater payment-to-income ratio were more likely to default on their loan.

One of the biggest disadvantages of payday loans, besides their high interest rates, is the number of scam lending companies. Consumers must do their due diligence and look for red flags before doing business with a payday loan lender. A few common red flags include:

  • Asking for your bank login info
  • Requiring repayment via wire transfer or money order
  • Requesting an upfront payment before the loan is disbursed
  • Being promised a loan over the telephone
  • Not disclosing all fees before accepting the loan
  • Websites that don’t list valid addresses and phone numbers
  • Companies that are based overseas

Reliable companies that offer the best personal loans will have a positive Better Business Bureau rating, so you can start there when looking for a legitimate installment loan lender. Afterward, check to see if the company is registered with your state’s Attorney General’s office or your state’s banking department, as this is a rule for all lenders and loan brokers.

Pros and cons of installment loans

Before deciding on whether an installment loan is right for you, it’s helpful to review the pros and cons.

ProsCons

Build credit

Stricter qualification requirements

Lower interest rates

Less flexible

Fixed interest rates

Often carry prepayment penalties

Fixed monthly payments

Temptation to borrow more than you need

Short- and long-term loans available

May require collateral

Pros

  1. Installment loans, when regularly paid on time, can help build your credit. Also, they add to your credit mix, which makes up 10% of your FICO Score.
  2. Interest rates for installment loans are typically lower than their line of credit counterparts. For example, a $15,000 personal installment loan with PNC Bank has interest rates between 5.99% and 7.79%, while its $15,000 line of credit has a starting rate of 10.50% as of Oct. 5, 2018.
  3. Another perk of most of these loans is a fixed interest rate that won’t increase in the future, even if the market changes.
  4. Budgeting is easy with installment loans, as they offer fixed monthly payments that remain the same throughout the life of the loan.
  5. Whether you need a short-term installment loan to cover an emergency root canal or a long-term loan to make a major home improvement, you’ll find both are readily available.

Cons

  1. Many installment loans have stricter qualification requirements. You can expect lenders to check your credit history and request proof of income.
  2. There’s less payment flexibility than what you’d experience with revolving credit, such as lines of credit and credit card accounts.
  3. Many states, such as Nebraska, allow financial institutions to charge prepayment penalties on their installment loans.
  4. Applicants are often approved for more money than they need, which leads to the temptation to borrow excess funds.
  5. Installment loans may require collateral, such as a certificate of deposit (CD) or savings account or the equity in your home. That puts your assets at risk if you are later unable to repay the loan.

How to qualify for an installment loan

Once you’ve identified a few legitimate lenders, you’ll want to make sure you qualify for an installment loan. Consider the following general requirements before you fill out the loan application:

  • Your credit score. Check your credit score for free with a site such as LendingTree, MagnifyMoney’s parent company, to know where your credit score falls. Experian lists a “good” FICO score as 700 and above and an “excellent” score as 800 and above. The higher your credit score, the less of a risk you appear to lenders, which increases your chances of approval. Having a low credit score doesn’t mean you can’t get a loan, but you may need a friend or family member with good credit who is willing to act as a cosigner.
  • Your credit history. Get a copy of your credit history by requesting a free report at AnnualCreditReport.com. This report is provided complimentary once a year by the three major credit reporting agencies (Experian, TransUnion and Equifax). Lenders will examine the report to see if you regularly pay your debts on time.
  • Your debt-to-income (DTI) ratio. The lower your DTI ratio, the better chances you have of qualifying for a loan. Wells Fargo lists 35% or less as ideal and 36% to 49% as adequate with room to improve. You can find your DTI ratio by adding up all your debt and monthly bills and dividing it by your gross monthly income.
  • Proof of stable income. Proving that you have a stable income is the best way to show the lender that you can repay the loan. Be prepared to provide pay stubs, tax documents, benefit letters and bank statements if requested.
  • Collateral. If you’re shopping for a secured installment loan, you’ll also need to have collateral. Gather together any CD or savings account statement if you’d like to use your savings as collateral. You may also want to determine how much equity you have in your home and use that as collateral.

Where to find installment loans

After you’ve determined that you qualify for a personal loan, you can begin comparing offers to find the best deal. There are several reputable lenders to consider.

Traditional banks

Banks such as Wells Fargo, PNC Bank, Citizens Bank and TD Bank offer installment loans. Besides finding the lowest APR, you’ll want to check for fees.

Keep in mind that each bank application may result in a hard pull on your credit, which can negatively affect your credit. Before shopping for rates, you may want to use our personal loan calculator to get an idea of what kinds of rates you can afford.

Credit unions

Another credible option is to apply for an installment loan from an established credit union, such as Alliant, PenFed and Navy Federal. Credit unions have some of the lowest APRs, which works in your favor by giving you a smaller monthly payment.

For example, Alliant Credit Union has a 12-month personal loan with a 6.24% APR, while Wells Fargo Bank starts its 12-month personal loans at 7.24% as of Oct. 5, 2018.

But with this type of lender, you may have to become a member before you can qualify for loans. Call the company to learn about its eligibility requirements. Navy Federal Credit Union, for example, accepts service members and their family, as well as Department of Defense civilians. PenFed welcomes volunteers, association members, those with a military affiliation and certain employees whose employers partner with the company.

Online lenders

Online lenders, such as Earnest, SoFi and Upstart, may be convenient options. Their applications can be completed online and in little time. Most of these companies also allow you to submit to a soft credit check to review rates. A soft credit check won’t affect your credit score.

Another perk in shopping for online lenders for an installment loan is how quickly you’ll receive your funds once approved. SoFi releases funds a few days after address verification. Upstart awards funds the next business day after acceptance.

Conclusion

If you do your homework and find a legitimate lender with favorable terms, an installment loan can be a great financial tool to meet your personal needs. You’ll easily be able to add the monthly payment amount to your budget and have a clear time frame of when the loan will be completely paid off.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Alicia Bodine
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Alicia Bodine is a writer at MagnifyMoney. You can email Alicia here

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Here’s Why You Should Avoid Cosigning a Loan for a Friend

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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You’re in a tricky situation: your friend, who you love and care about deeply, has come to you asking for your help getting a loan that they desperately need. You know the loan could benefit your friend, but you’re also unsure of the risks behind cosigning a loan.

The most important step you can take is to learn why cosigning a loan for a friend is rarely a good idea. That way, you can understand why you probably should avoid it.

Should you cosign a loan for a friend?

In general, you may want to avoid cosign a loan for a friend. Here’s why:

  • You become legally responsible for the loan. In the eyes of the lender, the full loan amount is 100% yours. That means if your friend doesn’t make payments, the two of you will be held responsible.
  • Your credit score could be affected. Should your friend miss even one payment, your credit score could be negatively impacted since the loan is considered to be in your name too. And if the borrower defaults on the loan completely, it could impact your credit score even more.
  • You could damage your friendship. Consider the risks to the relationship with the person you are cosigning a loan for if they are unable to pay back the loan. Is the risk of ruining your friendship worth it?
  • You could lose personal property. If a loan — such as a personal loan — requires any collateral, such as your car, house or other personal asset, you are at risk of losing your property should your friend default on the loan.

Reasons why you may or may not choose to cosign a loan

Here’s a more comprehensive look at reasons why you might choose not to cosign a loan:

  • You can’t afford the loan. You should not take the risk on of cosigning a loan unless you can afford to pay the loan in its entirety. Otherwise, you could liable in court or even have your assets seized as part of your state’s collection practices.
  • You need a loan for yourself. If you know you will need your own loan soon, cosigning a friend’s loan could prevent you from being eligible for a loan for yourself.
  • You’re concerned about your credit score. If you’ve had a history of bad credit, are trying to build up your own credit or just don’t want to see your credit score negatively affected, you need to be aware that cosigning a loan could hurt your own credit score if your friend misses payments or defaults on the loan all together.
  • Your friend has a history of bad financial decisions. You should know why your friend needs a loan. It’s within your right to decide that you won’t cosign a loan if you don’t agree with how they’ll use loan funds. If your friend tends to rack up debt, you’re also free to explain to your friend that you don’t feel confident they need the added debt.

That being said, there may be a few circumstances where it is acceptable to cosign a loan for a friend. For example:

  • You can afford to pay the loan completely. If you cosign a loan, you are agreeing to be responsible for the loan amount in the event that your friend is unable to pay it. So, if you can afford to pay off the entire loan amount and are willing to do so, you could cosign a loan with less risk of hurting your own finances. Aside from the money you’d be out for the loan amount, of course.
  • The loan is for both of you. If you are purchasing something together, cosigning a loan might be a logical move, as you will both be utilizing the item or asset. For family members, a parent might choose to cosign a loan so their child could potentially consolidate student loan debt at a lower interest rate.
  • You’re willing to take on the risk. Maybe you feel like your friend has no other options, this is a necessary step and you are fully aware of the risks involved. In that case, cosigning a loan is a personal decision that only you can make.

How to protect yourself when cosigning a loan

If you do decide to cosign a loan with a friend or someone else, you should also take steps to protect yourself as much as possible before the loan is enacted. You can minimize your risk by taking actions such as:

  • Don’t put down personal assets as collateral. If you’re willing to cosign on a loan, you shouldn’t wager more than that. Using your home, car or other personal asset as collateral only increases your risk.
  • Establish expectations in advance. You should sit down with your friend to establish expectations for the loan and repayment. It’s helpful if you can set out a plan in writing about the consequences if your friend misses payments or is unable to fully repay the loan.
  • Stay on top of the loan. Although it is recommended that you keep close tabs on the borrower to ensure that they are repaying the loan on time each month, you could also ask the creditor to inform you of any missed or late payments automatically. If the lender has an online system, you and your friend could also share the account information. That way, you could easily log into your account to review payment information.
  • Try negotiating loan terms. Rules will vary by lender and state, but you may be able to negotiate what you’re responsible for as a cosigner, such as limiting your liability to the loan principal balance instead of the full principal and interest amount. You can also try to negotiate responsibility for late fees, attorney fees or accrued court costs.

Other ways of helping your friend

Outside of cosigning a loan for your friend, there may be other ways that you can help, such as:

  • Assisting with a down payment. Perhaps you can’t afford to take on the risk of cosigning an entire loan for your friend, but you may be able to help them put together a down payment so that they may qualify for a conventional loan.
  • Lend them the money directly. To ensure that you would not be legally responsible for your friend’s debt and to avoid possible damage to your own credit score, you could consider lending your friend the money they need directly, either as a lump sum or in installments. It is advisable to get all loan terms in writing and to have the loan contract notarized if you do choose to DIY a loan.

The bottom line

Although you may want to cosign a loan with a friend to help them, taking on the legal responsibility of someone else’s debt is usually not a good idea for most people. Agreeing to become a cosigner means you run the risk of being liable for the loan amount and the possibility of your own credit score taking a negative impact.

You should carefully consider the risks you are willing to take and take steps to minimize them before agreeing to cosign a loan for a friend. In most cases, unless you can fully afford and are willing to pay off the entire loan amount, the cons do outweigh the risk of cosigning on a loan for a friend.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Chaunie Brusie
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Chaunie Brusie is a writer at MagnifyMoney. You can email Chaunie here

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Should You Use a Personal Loan to Build Credit? What to Consider

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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If you’ve been trying to build up your personal credit, you may have considered using a personal loan. Taking out a personal loan could show creditors that you can responsibly handle different kinds of debt and follow the terms to which you and your lender have agreed.

But how successful you are depends on your ability to pay the loan back within the given term limits. Here’s what you should consider before taking out a personal loan to build credit.

Pros vs. cons: Using a personal loan to build credit

There are both pros and cons to taking out a personal loan in an attempt to increase your credit score:

Pros

  • Add to your credit mix: A personal loan could help you diversify your credit mix, which accounts for 10% of your FICO score.
  • Stay current on payments: You could use a personal loan to refinance a debt or consolidate debts to a lower interest rate. Doing so could help ensure you stay current on payments, which positively impacts your credit.
  • May not have to put down collateral: An unsecured personal loan doesn’t require you to put up collateral to secure the loan. That means your house or other assets can’t be taken away if you default.
  • Lower your credit utilization ratio: A personal loan can also lower your credit utilization ratio if you pay off your credit card balance with your loan and keep the card open. Credit utilization is important factor in your FICO score, and it is basically the amount you owe divided by the total amount you have available to you. Personal loans don’t count toward it.

Cons

  • Fees, fees, fees: Depending on your credit score, you could be paying hefty interest fees over the length of the loan, in addition to any other fees your lender charges, such as prepayment penalties, late fees and origination fees.
  • Could increase your debt-to-income ratio: Taking out a personal loan could change your debt-to-income ratio. This could make future lenders less likely to let you borrow funds until some, or even most, of your personal loan is paid off.
  • Strict payment schedule: Personal loans are often issued for a period of between 24 to 60 months and offer little flexibility when it comes to adjusting payments. So if you lose your job or face other financial struggles, your lender may be unwilling to work with you to reduce or delay payments.

Is using a personal loan to build credit right for you?

A personal loan might make sense for you if your goal is to diversify your credit mix or lower your credit utilization ratio by paying off a credit card. It’s also a good option if you plan to use the funds at a lower interest rate to pay off other debt that’s charging you a higher interest rate.

A personal loan to build credit might not be a good option if you’re already struggling with paying off debt, if you have no prior credit history or if you could get a credit card with a lower rate of interest instead. If you can’t get a reasonable interest rate, a personal loan might not be a good choice, said David Gokhshtein, a New York-based member of the Forbes Finance Council.

“In most cases, people in this scenario already have lower credit scores, leading to very high interest rates they could be paying off indefinitely,” he said. “If the debt gets sent to a collection agency, it will further damage the person’s credit score.”

That said, it’s important you have a clear picture of your financial situation. Consider the following questions:

  • Is your credit score good enough to qualify for competitive interest rates?
  • Can you afford the cost of a personal loan?
  • Is taking out debt and repaying it with interest worth it to build your credit?
  • Do you have a good use for the funds?

Answering these questions could help you decide whether or not to move forward with this option.

How to take out a personal loan

The first thing you should do if you decide to get a personal loan is to check your credit score. A FICO score of 700, on a range that spans 300 to 850, indicates you have good credit and would be likely eligible for a variety of loan offers, including a personal loan at a reasonable rate of interest. Because FICO scores are seen as an accurate reflection of your creditworthiness, lenders rely on them in 90% of all decisions.

You’ll want to research your options for lenders before committing to a loan, as well. You can use MagnifyMoney’s personal loan marketplace to compare lenders. You may also look to local banks or credit unions.

If possible, apply for preapproval from your top lenders of choice. Preapproval will allow you to see rates and terms you might qualify for with a soft credit check, which won’t affect your credit score.

Consider the following when weighing your loan options:

  • Rates
  • Fees
  • Conditions
  • Lender perks, such as support in case of job loss

Once you decide on a lender, you can submit to a hard credit check to see your final rates and terms. Depending on the lender, you could get loan funds within a few business days.

Others strategies to improving your credit

Consider the following ways to build credit without accumulating any additional debt:

Get a credit builder loan. With this type of loan, the money you borrow is deposited into an interest-bearing account. As you make payments on the debt, your payments are reported to the credit bureaus. Once you pay off your debt, the loan funds and the interest they earned are released to you.

Charge only what you can pay in full each month. If you have a credit card, you could use to work on your credit. Just make sure you pay off the card in full each month. “It is imperative to create and use a simple budget to make sure you follow this rule,” said Freddie Huynh, the San Francisco-based vice president of credit risk analytics at Freedom Financial Network. “Being able to pay your bills on time is the most important factor in the calculation of your credit score, accounting for 35 percent.”

Review your credit reports regularly for accuracy and correct any errors you find. You can access credit reports from each of the three main credit reporting agencies once a year for free at www.annualcreditreport.com. “If any report shows any inaccuracy, follow the directions on each agency’s website to correct it,” Huynh said.

The bottom line

Carefully consider your options before taking out a personal loan. You should have a clear idea of how you’ll use the loan funds and what the total cost of the loan will be. Most importantly, if your credit has been damaged by poor financial habits in the past, you need to consider whether or not a personal loan is only a temporary solution to a larger problem.

“My biggest concern with anyone considering a personal loan to pay off high interest credit cards is that they are focusing on the symptom, not the cause,” said Todd Christensen, the Boise, Idaho-based education manager at Money Fit by DRS. “If the borrower is disciplined, it might make sense; otherwise, debt management through a nonprofit credit counseling agency could make more sense.”

While a personal loan can be one part of the credit building or repairing process, it’s not your only possible solution. In fact, Christensen said taking out a personal loan could be part of a multi-pronged strategy to boosting your credit. Still, a personal loan on its own could help depending on your finances — given that you properly research lenders, stay disciplined during repayment and take extra care of your money throughout the process.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Barbara Balfour
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Barbara Balfour is a writer at MagnifyMoney. You can email Barbara here

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