Installment loans: What they are and how they work

An installment loan is a common way to borrow money. In fact, you might already have one or two of your own.

Read on to learn more about installment loans and how they work.

Key takeaways

• An installment loan is a credit account that provides a lump sum to be paid off over time in equal monthly payments.
• Personal loans, auto loans, mortgages and student loans are all examples of installment loans.
• Installment loans typically have predictable monthly payments.
• If you’re approved for an installment loan, you may not have the flexibility to borrow additional money with the same loan.

Installment loans, also known as installment credit, are closed-ended accounts. Borrowers typically repay these loans over a set period of time at regular intervals for the same amount each payment. 

Some installment loans can be used for a variety of purposes, while others are geared toward specific financial goals, such as buying a house or paying for college.

When you take out an installment loan, you typically receive the money you’re borrowing or the item you’re purchasing at the start of the loan. Payments, which include any interest charges, are made at regular increments known as installments. You typically owe the same amount on each installment for a set number of weeks, months or years. Once the loan is paid back in full, the account is closed permanently.

Credit scores can have an impact on installment loans. That’s because lenders take creditworthiness into account when deciding whether to offer installment loans. And credit scores can also influence the interest rates and terms offered.

Some of the most common installment loans include personal loans, auto loans, mortgages, student loans, payday loans and buy-now, pay-later loans.

Each loan’s interest rate, repayment term, fees and penalties may be different. And installment loans can be secured or unsecured. This refers to whether borrowers need collateral to back the loan. 

Here’s a closer look at some types of installment loans:

Personal installment loans don’t have to be used for a particular purchase. They can be used to do things like consolidate outstanding debt, make home or car repairs, or pay unexpected bills. Most personal loans are unsecured.

Learn more about what credit score might be needed for a personal loan.

Auto loans can help you pay for a new or used car. An auto loan is secured by the car you buy. Auto loans usually have fixed interest rates and repayment periods that typically range from two to seven years.

Learn more about how to get a car loan.

A mortgage is used to buy a house and is secured by the house. There are lots of different types of mortgages. But the most common are repaid over 15 to 30 years. 

Learn more about different types of home loans and the credit score you might need to buy a house.

Whether federal or private, student loans are unsecured and help pay for undergraduate, graduate and other forms of postsecondary education. Unlike other installment loans, you usually don’t have to start repaying a student loan straight away. 

Learn more about how to apply for a student loan.

You might have come across a buy-now, pay-later, or BNPL, loan while shopping. Some retailers may offer this option at checkout and call it point-of-sale financing. In general, BNPL loans let you spread out payments over a number of installments instead of paying for what you purchase right away. The repayment schedule can range from a few weeks to multiple years, depending on the retailer and purchase.

A payday loan generally describes a short-term, high-cost small personal loan that’s designed to be repaid on your next payday. The terms and structure can vary by state, payday lender and individual loan. 

In exchange for a payday loan, the borrower usually gives the lender a postdated check for the full amount borrowed, plus fees. Or the borrower might authorize the lender to electronically withdraw that amount from their bank account on the due date.

Learn more about the risks involved with payday loans.

Like all types of credit, an installment loan comes with pros and cons. Whether it’s the right choice for you depends on your specific situation. But here are some points to consider:

The benefits of installment loans include their:

• Ability to cover a large expense: Installment loans can give you fast access to the money you need for bigger purchases.
• Predictable, regular repayments: With an installment loan, you know what your installment amount is going to be. And this can make budgeting easier.
• Chance to refinance: If interest rates fall or if your credit score improves, you might get a chance to refinance. If your installment loan is a mortgage, for example, refinancing could lower your monthly mortgage payments or shorten your repayment schedule. Keep in mind that there could be other costs and drawbacks involved with refinancing.å

There can be some drawbacks to installment loans, including:

• They’re not open-ended: It’s unlikely you’ll be able to add to your loan amount if you need more. 
• A potentially long commitment: Some installment loans come with long repayment terms. This means a borrower has to commit to making regular payments over a long period of time. And be sure to read through the loan’s terms and conditions. There may be prepayment penalties—that is, penalties for paying the loan off early.

An installment loan—and how you use it—could have an impact on your credit scores. But when it comes to how an installment loan could affect credit, it can be hard to predict. This is because there are different credit-scoring models from companies like FICO® and VantageScore®.

How an installment loan affects you specifically also depends on your financial situation. If your installment loan is reported to credit bureaus, it could help or hurt your credit scores when you’re:

• Applying for a loan: Applying for a loan could trigger a hard credit inquiry. According to the Consumer Financial Protection Bureau (CFPB), these kinds of inquiries could negatively affect your credit. 
• Using a loan: You could hurt or help your credit scores depending on whether you use the credit responsibly and make payments on time. Your credit mix can also change when you add a new loan. And according to the CFPB, that’s a factor used to calculate your credit scores.

Keep in mind that there are other factors that can affect your credit scores. And you’ll need to keep an eye on them all if you want to get and keep good credit scores.

An alternative to an installment loan is a revolving credit account. Unlike installment credit, revolving credit is open-ended. This means it can be used and paid down repeatedly for as long as the account remains open and in good standing.

Some examples of revolving credit accounts include:

• Credit cards: Credit cards allow you to borrow up to a set credit limit to make purchases. 
• Personal lines of credit: Like a credit card, a personal line of credit has a set credit limit. But with a personal line of credit, you typically access funds with special checks or by requesting a deposit to your checking account.
• Home equity lines of credit: A home equity line of credit (HELOC) is another open-ended credit account. HELOCs are secured loans, using a home’s equity as collateral.

Like credit cards, installment loans can be an option in many different situations, from making a big purchase to consolidating your debt. And they take many different forms. 

If you’re considering an installment loan, a good first step is to begin monitoring your credit to understand where you stand. You can request free copies of your credit reports at AnnualCreditReport.com. Or you can use CreditWise from Capital One. CreditWise is free to everyone—not just Capital One customers. And using it won’t hurt your scores. You can also use the CreditWise Simulator to see how borrowing money might affect your credit.