Simply put, an installment loan is a loan where funds are given as a lump sum upfront and then repaid over a set period of time. The loan is then paid back with interest over a fixed number of regular payments (typically monthly), called installments. The payment amounts, payment frequency, and set interest rate are determined by the terms of the loan agreement.
Installment loans can be secured or unsecured.
Secured loans involve collateral, which is an asset that the borrower will forfeit to the lender if the debt cannot be paid. For example, if a borrower takes out a loan on a motorcycle and uses the motorcycle as collateral for the loan, the lender can repossess the motorcycle if the loan doesn't get paid off. It's also common for secured loans to have downpayments, or a set amount of money that must be paid upfront in order to take out the loan.
An unsecured installment loan allows the borrower to pay back the loan without using an asset as collateral. These loans typically come with a higher interest rate than secured loans, but usually do not require downpayment's.
For both secured and unsecured loans, interest rates may be determined by the borrower's credit score, outstanding debt, and income.
Installment loans vs credit cards.
- Monthly paymentsInstallment loans usually require equal monthly payments until the balance is paid off in full. Credit card monthly payments can fluctuate depending on the interest rate and outstanding balance. With credit cards and revolving credit, borrowers can choose to pay between a minimum payment or up to the outstanding balance. The advantage is having the ability to pay a loan faster means paying less interest. However, if borrowers don't make large enough payments fast enough, their debt could accumulate quickly to an amount that's difficult to pay off.
- Available fundsWith an installment loan, the borrower is given one lump sum available upfront, and they must pay back the lump sum plus interest, regardless how much of it they use. With credit cards, the amount of money available depends on the borrower's credit limit. Borrowers can use up to the amount of their credit limit, and are only charged interest on their outstanding balance.
- Interest ratesMost installment loans come with a fixed interest rate that doesn't change for the duration of the loan term. Credit cards usually have variable interest rates that can go up or down for a variety of reasons, for example when a borrower is late in making monthly payments, when a promotional rate expires, or when there is market competition from other credit card companies.
The Bottom Line
Installment loans are an option that allows borrowers to get a large amount of money to use right away as they see fit. It is important to understand the loan terms in regards to the fixed monthly payment amounts and set interest rate, and any other possible fees or penalties. An installment loan makes budgeting easier and helps to avoid missing payments since it's possible to calculate the exact payment amounts and due dates over time.
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