How Does an Installment Loan Work?

An installment loan is financing that you repay with regular installments over a period of time. Mortgages, auto loans, personal loans and some business loans are common examples of installment loans. The purpose of borrowing in this way is to spread out the costs of a large purchase while acquiring the item up front.

Basic Loan Terms

  • Fixed payment amount
  • Interest rate
  • Loan term

The fixed payment is the amount you pay toward the loan on a regular basis, often monthly. With a mortgage, for instance, you pay off a 30-year fixed loan with set monthly payments that go toward principal, interest and, in some cases, taxes and insurance. Each payment reduces the amount you owe on the principal balance. Credit cards aren't installment loans because monthly payments aren't fixed.

The interest rate on an installment loan impacts the fixed payments as well as the total financing costs over the life of the loan. The loan term is the length of the repayment period. Fifteen and 30 years are common repayment periods on mortgages. Auto loans and personal loans are typically for a much shorter length.

Secured or Unsecured

A key feature of an installment loan is whether it is secured or unsecured. A secured installment loan such as a mortgage, auto or boat loan requires that you put up property as collateral to get financing or a more reasonable interest rate. The primary concern is that the creditor may repossess your property if you fail to repay.

Unsecured loans don't carry that risk, though you can take a serious credit score hit if you default. Personal loans are often unsecured. To get a favorable rate on an unsecured personal loan, you need excellent credit. Your proven reliability in paying off debt plays a big part in whether you are approved for the loan.

Financial Benefits

Primary financial advantages of an installment loan relative to revolving credit include:

  • Predictable monthly payments
  • Early repayment options
  • Low rate and tax deduction opportunities