Installment Loan: What Is It & How It Can Affect Your Credit?
In this article, you will find that installment loans explained very well. An installment loan is a type of loan that can be taken out to borrow money and is typically utilized for making a single, significant purchase such as a car, house, or college tuition. The borrower gets a one-time payment after the lender gives their approval, and then they begin making regular payments, sometimes known as installments, to pay back the loan over the course of a predetermined period of time.
Installment loans function in a different manner compared to revolving credit such as credit cards, which offer a credit line from which one can continuously draw money rather than a set amount to repay. When the money from an installment loan is paid back, the account is closed; but, if you have revolving credit, you have the option of borrowing the money again.
If you are considering applying for a loan with installments, the following is the information that you need to know about the loans.
Different Variations of Installment Loans
Installment loans often fall into one of two basic categories: secured and unsecured.
A secured loan must have collateral, which can be in the form of an asset or piece of property owned by someone else. If you are unable to repay a loan, the lender has the right to take possession of the collateral; for instance, if you took out a loan to purchase a vehicle, the lender has the right to take possession of the vehicle. Personal loans are an example of an installment loan type that is typically unsecured, which means they do not require collateral to be secured against the loan.
The following is a list of the most common types of installment loans that are available to borrowers today:
- Personal loans: These are installment loans that can be used for a variety of purposes, including debt consolidation, paying for medical expenses, making home improvements, or even paying for a wedding. Traditional financial institutions such as banks and credit unions may also offer these kinds of loans, in addition to the online-only creditors who are solely focused on providing speedy transactions. There is a wide range of interest rates and loan amounts available for personal loans, and the amount you can borrow is highly dependent on your credit history.
- Auto loans: A type of installment loan that can be used to purchase a vehicle. Because the payments are secured with the vehicle as collateral, you run the danger of not being able to keep possession of your car if you are unable to make them. On the other hand, as compared to unsecured loans, the interest rates on auto loans are frequently significantly lower. For instance, the Federal Reserve states that the average interest rate for a loan to finance a brand-new vehicle over a period of 48 months during the fourth quarter of 2019 was 5.45 percent. A personal loan with a term of twenty-four months had an average interest rate of 10.21%.
- Mortgages: A specific kind of secured installment loan that is typically used to finance the purchase of a home. Mortgage interest rates are often lower than those for unsecured loans since your home is used as collateral to protect the lender, similar to how collateral is used when you get an auto loan. On the other hand, this indicates that if you are unable to keep up with the payments on your mortgage loan, your property could be repossessed.
- Student loans: A type of installment loan that can be obtained from either the federal government or a private lender and used to finance one’s education after high school. There is a distinction between federal student loans and private student loans in regard to the interest rates, terms, various methods for repayment, and various programs that cancel debt on student loans.
- Payday loans: A subset of the type of loans known as installment loans. They are marketed to borrowers as a tool that will assist them in making it until their next payment is due. On the other hand, they are renowned for keeping people in a cycle of debt, and many people consider them to be a form of predatory lending because of the extremely high-interest rates and other associated fees. Instead, you should consider alternatives.
Revolving vs. Installment Credit
There are two types of credit that can be obtained; however, revolving credit and installment loans operate significantly differently from one another. Revolving credit, such as credit cards and home equity lines of credit (HELOC), is more flexible than installment loans, which are more like one-time transactions and allow you to borrow a predetermined amount of money. Installment loans, on the other hand, are more like one-time transactions.
For instance, when you are approved for a credit card, you are also given a credit limit, which is the maximum amount of money that you are permitted to borrow as long as all of your balances are paid in full. If you have a debt, the issuer will require that you make a minimum payment to them each month, after which you will only be charged interest on the outstanding balance.
Consider the scenario in which you apply for and are granted a new credit card with a limit of $5,000. If you have a balance of $1,000, you will only be charged interest on that amount; you will not be charged interest on the $5,000. Once you have repaid that initial loan of $1,000, you will then be eligible to borrow an additional $5,000.
This provides a lower level of reliability but a higher level of flexibility when compared to an installment loan. In general, the interest rates associated with credit cards are higher than those associated with the majority of other types of loans; this is especially true if you are qualified for the more favorable installment loan rates. If you just only make the minimum payments on a revolving credit account, you run the risk of becoming mired in debt and being unable to get out. Therefore, revolving credit should primarily be utilized for covering unforeseen expenditures or for progressively paying off infrequently substantial purchases such as furniture or television that do not warrant the need for a loan due to their low value.
How Installment Loans Can Affect Your Credit
Your credit score may improve or suffer as a result of taking out a loan, regardless of the sort of loan it is, but taking out an installment loan, in particular, might have either of these effects. The following is how:
- Payment history: According to the FICO credit scoring methodology, the most important factor in determining your credit score is your payment history, which accounts for 35% of the total score. If you make all of the payments on your installment loans on the dates that they are due, your credit score will improve. On the other hand, your credit will take a hit if you make payments that are late, get behind, and then miss payments altogether.
- A mix of credit: Having a number of different credit accounts can also be beneficial to your credit score. If you do not currently have a loan, applying for one could be beneficial to your credit score; however, this is only the case if you are approved for a loan. It is not a smart idea to obtain a loan that will have to be accommodated within your financial plan in order to fulfill this need. Additionally, the process of applying for a new credit line could result in a hard inquiry being made on your credit report, which could potentially bring your score down.
- Utilization of credit: According to FICO, the ratio of how much of your available credit you are using is a significant factor in determining your credit score. This ratio is responsible for approximately 30% of your total score. This number indicates what percentage of your available credit is currently being utilized at any one time. Lenders may grow concerned about your overall debt burden as well as your credit score if you use it to an excessive degree. If you already have a high credit usage rate due to large credit card balances or past loans, adding a new loan to your credit file could cause your score to drop. This could happen if your credit utilization ratio is already high.
How to Determine Whether Installment Loans Are Right for You
Your credit history and your financial plan will both be impacted in the long run by the use of an installment loan.
When you are presented with an offer for a loan, give serious consideration to whether or not you have room in your finances for a new monthly payment. Think about it: If you suddenly found yourself in a difficult financial situation, would you still be able to pay your bills? Do you have a contingency reserve in your savings to cover bills like these if anything unexpected happens?
If you are unsure about whether or not you will be able to comfortably pay off the loan within the allotted time, you should talk to the lender about the possibility of making changes to the offer. It’s possible that you need a smaller loan or a longer term in order to make your monthly payments more affordable.
Consider utilizing different forms of financing, such as a credit card, in order to cover some kinds of expenses. Even though the interest rates on personal loans may be lower than the interest rates on credit cards, for example, many credit cards provide introductory offers of 0% APR for a period of 12 to 18 months. This gives you the opportunity to pay off your debt without being charged any interest during this time.
However, before you use a credit card with 0% interest, make sure you carefully analyze the usual APR and that you will be able to handle the payments even if you still have a balance when the new rate takes effect. If you make responsible use of credit cards and installment loans, you’ll have a better chance of reaching your financial goals and keeping your credit score in good standing.