What Are Installment Loans and How Do They Work?

Posted on December 14, 2020 in Banking

When making a large purchase, you may find yourself looking for different methods of funding outside of your personal bank account. Purchases such as vehicles, homes, or other forms of property can be a massive expense, but can also be seen as a necessity. 

Loans can be simple — you borrow a certain amount of money, and you pay a certain amount of money for an extended period of time. 

Understanding exactly what you’re paying for allows you to gain a better understanding of the process, giving you the chance to make better financial decisions along your path of financial stability. 

What is an Installment Loan? 

When making a large purchase, you may find a loan type that talks about making a specific number of payments, often called installments. Installments are specifically calculated to cover the cost and interests, and the cost of the payments is often set. 

Most commonly, installment loans can be found with automotive and home loans. These loans are displayed in a set payment price, over a specific period of time. An example would be paying $800 a month for a total of 30 years, where you know the payment would not change without a contracted change. 

Installment loans can sometimes be seen with smaller purchases as well. Widely known is the installment payments found on television advertisements, with their “3 easy payments of $9.99” type promotions. 

This form of payment is ideal for budgeting, since payments often remain stable. 

What Factors Affect Getting Approved?

With installment loans most commonly being large payments over an extended period of time, lenders have quite a bit of focus on debt-to-income ratios and credit scores. 

Debt to Income 

Debts to incomes compares your overall debts being paid, along with your monthly income. This gives them a general idea of how much you would have left over at the end of the month, and how likely you would be to be able to make payment on time. 

Credit Score  

When considering your credit score, think of this like your report card for debt. It will tell the bank how risky it would be to hand you a certain amount of money. With a range of 300-850, your score will give a general idea to the lender, who can see the fine details if they choose to review that deep. 

Your credit score is based on factors such as the age of your accounts, if you have made your payments on time, how much debt you have, and how many accounts you have open. This will help them better understand if you have been stable, or if  you have been living on the edge of debt. 

Types of Installment Loans

Collateral

Often referred to as equity, collateral is an object of value placed in the ownership of the lender until your loan is paid in full. When purchasing something such as a house, car, or business the property is placed as collateral on the loan. 

For banks, this is a form of security for lending you the money. If you were to stop payment or attempt to evade your debts, the bank would then be able to take ownership of this property. In most cases, if property is taken, banks will sell the property to cover the remaining value of the loan. 

Smaller loans, such as personal loans, may not require a collateral. 

Student Loans

While we would prefer paying less for the things we need, student loans have become a major form of installment loans with often customizable payment options. It’s said that around 70% of adults have some sort of student loans, making this one of the primary forms of installment lending. 

A common method to paying off this debt is through installment payments, allowing you to make steady payments towards your goal of becoming debt free. 

How Do Installment Loans Work?

Installment loans benefit the borrower and the lender equally. 

For the borrower, installment loans can be customized and altered (within reason) to match a given need. If you’re looking for funding for nearly anything, these loans can be short term or long term, focusing on steady payments between a couple dollars to thousands. 

These loans benefit the lender by creating a steady income and stability found with many equity based loans. This allows the lender to better budget their incomes and know you’ll continue to make payments. 

Refinancing

When talking about long term debts such as mortgages and auto loans, you may hear the term refinancing. The chances are, you weren’t concerned about future term movements and changes in APR or your credit score when you decided to make your purchase. You were most likely more concerned with actually making your purchase. 

As time goes on, you’ve made all of your payments on time. This means your credit score has continued to benefit your credit history, and your debt to income ratio continues to lower as your debts continue being paid. To give you more advantage, you have paid down your credit card debts allowing your credit utilization to drop into great standing, under 10%. 

If you were to get a loan for your house now, you could expect a much better rate. Oh, and let’s not forget the fact that you would be borrowing much less since you’ve paid your load down over the years. 

When you create a new loan to cover something already used in an equity loan, this is known as refinancing. 

In many cases, a bank will allow refinancing after so many years written in your original contract. Since you have time and experience with that bank, they are more likely to refinance at a lower rate making your APR and payments more manageable. 

If your bank has been less than ideal during your loan process, you have the option to refinance elsewhere, too.

It’s important to remember the focus is you. When looking at annual percentage ratios, you can expect to spend tens of thousands of dollars when purchasing even a smaller house just on APR. This is money put directly into the bank’s drawers and has no effects on your account. Your goal should be to lower your APR if possible. 

Downfalls to Installment Loans 

Of course, there are some downfalls to installment loans as well. 

Installment loans are often a set amount for a set thing. This means if you take out a loan to purchase a motorhome for your family’s vacation, and after a few years something breaks, you generally can’t pull from this account to make repairs. 

In most cases this isn’t an issue, but it is important to segregate these fixed debts from your revolving debts when considering your budget. These funds can’t be used as an emergency fund, like some other forms of debt such as credit cards with an available balance. 

These loans are often based quite heavily on your credit reports, and your current financial status. This can be difficult for some consumers, especially when in financial burden or sudden growth, which may not appear on your credit score for quite some time. It’s important to take control of your financial situation and improve your credit on your path to financial independence, but it does take time. 

When signing up for an installment loan, you essentially sign a contract focused on set payments. It’s important to understand exactly what you’re paying and the possibility of fees and other charges that could apply. Ultimately when signing any contract, you are legally bound to the terms. It’s important to take the time to either understand exactly what’s being said, or bring someone along that can. 

The Takeaway: Installment loans are loans with a set payment (i.e. installment) you pay every month, with minimum monthly payments, APR, and other terms often dependent on your credit score and debt to income ratio. Almost every loan you take out will be an installment loan.

Installment loans have remained the go-to option for many large purchases, such as homes and vehicles. They give you the financial security of knowing exactly how much you’ll need to pay this month, and next month, and the month after that. 

While you should take caution when taking out any loan, understanding how to compare APR and the importance and value of your credit report can set you up for future success. It’s important to use the knowledge found within Turbo Finance to allow you to take control of your finances today, and plan for tomorrow. 

Sources 

https://www.investopedia.com/terms/c/collateral.asp

https://www.pennymacusa.com/refinancing/how-refinancing-works#:~:text=Refinancing%20is%20the%20process%20of,to%20a%20fixed%2Drate%20mortgage.

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