What is an installment loan?
From houses to cars, just about every major purchase requires a loan of some kind. But beyond mortgages and auto loans, there’s an entire world of personal loans available to folks today. Increasingly, more people are turning to installment loans to pay for home improvements, cover unforeseen expenses or consolidate their debt.
If you’re thinking about taking out a personal installment loan to cover new home repairs or fund a DIY project, there are some things you should know first. Let’s take a look at how installment loans work and when they make the most sense to use.
Defining installment loans
As the name suggests, installment loans are personal loans that are repaid over a specific number of scheduled payments. Note that a mortgage or car loan could be considered an installment loan because they both cover a set number of payments across a predetermined length of time. For instance, conventional 30-year fixed rate mortgages are, by definition, installment loans.
But that’s not what we’re talking about here. We’re focusing on personal installment loans, which function a little bit differently. What often makes personal installment loans so enticing to cash-strapped individuals is that they are unsecured loans — that is, they don’t require any collateral. So, as long as you meet the lender’s qualifications, you can secure a loan without worrying about the lender recovering any of your assets in the event of a default. Because lenders take on more risk with an unsecured loan, they’re more likely to attach higher interest rates and require a stronger credit history from borrowers.
Personal installment loans also usually operate on a smaller scale compared with a mortgage. You might take out a personal loan of, say, $5,000 to pay for a kitchen makeover or get rid of all of your credit card debt in one fell swoop. That’s still a good chunk of money, but it pales in comparison to the tens of thousands you would spend on a car or the hundreds of thousands you would need to buy a house.
Personal installment loans are typically short-term loans, often anywhere from 12-96 months, making them comparable to the length of an auto loan. That’s a far cry from a 30-year or even a 15-year fixed rate mortgage.
How do installment loans work?
Like any loan, the first step to securing a personal installment loan is to submit an application. The advent of digital loans has made this process much simpler and faster than before. After you’ve submitted some information about your personal financials and the lender has reviewed your credit report, you should receive a response within a matter of days, if not hours.
The lender will weigh a variety of factors when considering your application, including your:
- Credit score
- Monthly income
- Debt payment history
- Debt-to-income (DTI) ratio
With that information in hand, the lender can make an informed decision about whether you’ll be able to repay your loan in full within the set timeframe. Lenders will also reference your financial status and history to decide the exact terms of the loan, including your interest rate and the length of the loan itself. Often, borrowers can choose from a variety of loan options, depending on the repayment schedule and how much money they’re comfortable paying each month.
Once your loan has been approved, you can decide how you would like those funds to be made available to you. The quickest way is for the lender to simply deposit the money into your bank account as one lump sum. There are other options to consider, though. For instance, if your goal is to pay outstanding credit card balances, you could request that the lender divvy up the loan funds among your various credit card accounts.
How do I qualify for an installment loan?
Arguably, your credit score is the most important factor lenders will weigh when deciding both your eligibility and the terms of your personal loan. Lenders view borrowers with higher credit scores as being more likely to pay back the loan on time. Generally speaking, the higher your credit score, the better loan terms you’ll receive.
Check out these credit score ranges to get a sense of what your own credit history says about your loan application:
- Poor: Below 580
- Fair: 580-669
- Good: 670-739
- Very good: 740-799
- Exceptional: 800-850
Different lenders will have their own credit score requirements, and they don’t exactly publicize that information. Still, it’s fair to say that people with credit scores falling into the “poor” range are less likely to be approved for a personal installment loan. The same holds true for anyone who has no credit history at all.
Your approval prospects increase as your credit score goes up. More importantly, lenders are probably going to extend more generous loan terms to people with “very good” or “exceptional” credit scores. Those perks include lower interest rates, longer repayment schedules and more repayment options.
How do I calculate loan repayment?
As with any type of installment loan, it’s important to look at the total cost of the loan rather than the loan amount itself. Once you account for interest, additional fees and the length of the loan, you could wind up paying a lot more than you initially thought.
Most lenders will be completely transparent about the total cost of your personal loan before you agree to anything, but it’s always a good idea to know how to calculate your loan repayment just in case they aren’t so forthcoming.
There are three components you need to look at to understand how your loan costs add up:
- Principal: In other words, the amount of money being lent to you
- Interest rate: Personal loans often use compound interest rates that increase with each year of the loan
- Additional fees: Origination fees are often tacked on to personal installment loans
Let’s say you want to take out a $5,000 personal installment loan to renovate your kitchen. A lender’s offering a 5% interest rate on a 48-month loan, plus a $500 origination fee. How much are you actually spending?
- Principal: $5,000
- Interest: $1000 ($250 a year for four years)
- Origination fee: $500
- Total cost: $6,500
In this scenario, you would wind up paying $1,500 to get immediate access to those funds.
Are personal installment loans a good idea?
It really depends on your particular circumstances and financial status. You need to weigh the pros and cons of any loan offer to decide if it’s worth the cost. In our above example, you may be better off waiting to save up enough money to pay for the kitchen renovation in full rather than eat the added cost of taking out a personal loan. On the other hand, if you’re looking to put your house on the market and want to bump up the sale price, then you might decide those renovations can’t wait.
In general, these are the factors you should think about when considering a personal installment loan:
- Interest rate: Even slight fluctuations in interest rates can have a noticeable impact on the total cost of a loan.
- Length of the loan: Longer repayment schedules may increase your compound interest. You also need to think about the ongoing impact your monthly loan payments will have on your budget.
- Fees: Origination fees and other added costs can significantly contribute to the total cost of your personal loan.
- Penalties: Nonpayment penalties and late fees are very common with personal loans. You may also face penalties for paying off your loan earlier than your agreed-upon timeframe.
- Credit score: Any loan you take out or hard inquiry of your credit history will affect your credit score. If you plan to have your credit checked in the near future, say to apply for a mortgage, you may want to space out those inquiries.
How to find the best installment loans near you
As we said earlier, consumers have more digital loan options to consider today than ever before. That means you don’t need to limit yourself to local banks and lenders. Many financial services websites do a great job curating the best personal installment loans available, ranking lenders according to interest rates, acceptable credit scores, maximum loan amounts and other criteria. Lists are typically updated each month, so the information’s usually pretty up to date.
Be sure to review all of your options and take a hard look at the fine print before agreeing to anything. You should know exactly what you’re getting yourself into so there aren’t any unpleasant surprises.
Consider alternatives to installment loans
Personal installment loans aren’t the only way to get your hands on some extra money — far from it. If you’re a homeowner, then you have several financial tools at your disposal, including:
- HELOC mortgages
- Cash-out refinances
A home equity line of credit (HELOC) lets you tap into some of the equity you’ve built up in your home to gain additional funds. It’s important to keep in mind that you’re using your house as collateral when you use HELOC mortgages, so you want to be sure you won’t fall behind on your payments.
A cash-out refi is another way to turn your equity into funds you can spend on home renovations, daily expenses and anything in between. Just like a HELOC, there are caveats you’ll want to consider. For one, you’re taking on a larger loan amount than your original mortgage. Secondly, you’re extending the length of your home loan, possibly even resetting the clock completely on it.
In the right circumstances, though, a cash-out refi can be a great way to get you the money you need while taking advantage of equity you’ve already established. Always weigh your options carefully before making a decision about any loan, whether it’s a personal installment loan or a 30-year mortgage.
Installment loans can include any loan that requires borrowers to repay those funds at regular intervals across a specific length of time. While mortgages, car loans and student loans all fit that definition, personal installment loans usually involve smaller sums of money. People often use personal installment loans to cover unexpected costs like auto repairs, consolidate existing debt or pay for larger purchases like a home renovation project.
If you’re considering a personal installment loan should take the time to calculate exactly how much you’ll wind up spending, factoring in interest rates, compound interest, possible penalties and extra fees. A personal loan can be useful in some scenarios, but it isn’t the right financial tool for everyone, so be sure to do your due diligence before making a decision.