What Is an Installment Loan and How Do They Work?

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Personal Loan

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.

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Alicia Bodine
Alicia Bodine |

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

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