An "installment loan" is a broad, general term that refers to the overwhelming majority of both personal and commercial loans extended to borrowers. Installment loans include any loan that is repaid with regularly scheduled payments or installments. Each payment on an installment debt includes repayment of a portion of the principal amount borrowed and also the payment of interest on the debt.
The main variables that determine the amount of each regularly scheduled loan payment include the amount of the loan, the interest rate charged to the borrower, and the length or term of the loan.
- Installment loans are personal or commercial loans that borrowers must repay with regularly scheduled payments or installments.
- For each installment payment, the borrower repays a portion of the principal borrowed and also pays interest on the loan.
- Examples of installment loans include auto loans, mortgage loans, and personal loans.
- The advantages of installment loans include flexible terms and lower interest rates.
- The disadvantages of installment loans include the risk of default and loss of collateral.
The Basics of Installment Loans
Common examples of installment loans are auto loans, mortgage loans, or personal loans. Other than mortgage loans, which are sometimes variable-rate loans where the interest rate changes during the term of the loan, nearly all installment loans are fixed-rate loans, meaning the interest rate charged over the term of the loan is fixed at the time of borrowing.
The regular payment amount, typically due monthly, stays the same throughout the loan term, making it easy for the borrower to budget in advance to make the required payments.
Collateralized vs. Non-Collateralized
Installment loans may be either collateralized or non-collateralized. Mortgage loans are collateralized with the house the loan is being used to purchase, and the collateral for an auto loan is the vehicle being purchased with the loan.
Some installment loans (often referred to as personal loans) are extended without collateral being required. Loans extended without the requirement of collateral are made based on the borrower's creditworthiness, usually demonstrated through a credit score, and the ability to repay as shown by the borrower's income and assets.
The interest rate charged on a non-collateralized loan is usually higher than the rate that would be charged on a comparable collateralized loan, reflecting the higher risk of non-repayment that the creditor accepts.
The Installment Loan Process
A borrower applies for an installment loan by filling out an application with a lender, usually specifying the purpose of the loan, such as the purchase of a car. The lender discusses with the borrower various options regarding issues such as down payment, the term of the loan, the payment schedule, and the payment amounts.
For example, if an individual wants to borrow $10,000 to finance the purchase of a car, the lender informs the borrower that making a higher down payment could get the borrower a lower interest rate, or that the borrower could obtain lower monthly payments by taking out a loan for a longer term. The lender also reviews the borrower's creditworthiness to determine what amount and with what loan terms the lender is willing to extend credit.
The borrower ordinarily retires the loan by making the required payments. Borrowers can usually save interest charges by paying off the loan before the end of the term set in the loan agreement. However, some loans impose prepayment penalties if the borrower pays off the loan early.
Borrowers generally have to pay other fees in addition to interest charges, such as application processing fees, loan origination fees, and potential extra charges such as late payment fees.
Advantages and Disadvantages
Installment loans are flexible and can easily be tailored to the borrower's specific needs in terms of the loan amount and the length of time that best matches the borrower's ability to repay the loan. Installment loans let the borrower obtain financing at a substantially lower interest rate than what is usually available with revolving credit financing, such as credit cards. This way, the borrower can keep more cash on hand to use for other purposes, rather than making a large cash outlay.
For longer-term loans, a disadvantage is the borrower might be making payments on a fixed-interest loan at a higher interest rate than the prevailing market rate. The borrower may be able to refinance the loan at the prevailing lower interest rate.
The other main disadvantage of an installment loan stems from the borrower being locked into a long-term financial obligation. At some point, circumstances may render the borrower incapable of meeting the scheduled payments, risking default, and possible forfeiture of any collateral used to secure the loan.