Installment loans: What they are and how they work

An installment loan is a common way to borrow money. You might already have one or two.

Keep reading to learn about installment loans and how they work.

What you’ll learn:

• An installment loan is a type of closed-end debt.

• Installment loans are different from credit cards, which are a type of revolving credit.

• Installment loans are often distributed in a lump sum and then repaid in equal amounts over time.

• Personal loans, auto loans, mortgages and student loans are all examples of installment loans.

Installment loans, also known as installment credit, are closed-end accounts. Borrowers typically repay these loans at regular intervals for the same amount each payment. 

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

If you’re approved for an installment loan, you usually receive the money you’re borrowing or the property you’re purchasing at the start of the loan. 

Payments typically include interest charges, and are made at regular increments known as installments. They are called “closed end” because once the loan is paid back, the account is closed.

Lenders take creditworthiness into account when deciding whether to offer installment loans. And credit scores can also affect interest rates and terms offered.

Installment loans can take many forms. They can be secured or unsecured, depending on whether collateral is involved. Interest rates, repayment terms, fees and penalties also vary. Here’s a closer look at some types of installment loans:

Personal installment loans don’t typically 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.

Auto loans are used to pay for vehicles, which also act as collateral for the loan. Auto loans usually have fixed interest rates and repayment periods that range from two to seven years.

A mortgage is a secured loan used to buy a house. There are different types of mortgages, but some of the most common are repaid over 15 to 30 years.

Student loans are unsecured and help pay for undergraduate, graduate and other forms of postsecondary education. Unlike with other installment loans, borrowers usually don’t have to start repaying student loans right away.

Some merchants offer BNPL options at checkout. They let buyers spread out payments instead of paying in full right away. Repayment schedules depend on the merchant, lender and purchase.

A payday loan generally describes a short-term, high-cost small personal loan designed to be repaid quickly. The terms and structure can vary by state, payday lender and individual loan. Payday loans can be risky, which is why they’re banned in some states.

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.

Like all types of credit, an installment loan comes with pros and cons. Here are some points to consider when deciding if one is right for you.

The benefits of installment loans include their:

• Ability to cover a large expense: Installment loans can give you fast access to money you need for bigger purchases.

• Predictable, regular repayments: You’ll know what your payment amount is going to be, which can help make budgeting easier.

• Chance to refinance: If interest rates fall or if your credit score improves, you might be able to refinance. If your installment loan is a mortgage, for example, refinancing could lower your monthly mortgage payments or shorten your repayment schedule. Just keep in mind that there could be other costs involved with refinancing.

There can be some drawbacks to installment loans, including:

• They’re not open-end: You probably won’t be able to increase your loan amount.

• They’re potentially long commitments: Some installment loans require you to make regular payments over a long period. And there may be prepayment penalties for paying the loan off early.

How you use an installment loan could have an impact on your credit scores. 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.

An alternative to an installment loan is a revolving credit account. Unlike installment credit, revolving credit is open-end. 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: A personal line of credit also has a set credit limit. But 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-end credit account. HELOCs are secured loans that use a home’s equity as collateral.

There are different types of installment loans available, whether you’re making a big purchase or consolidating your debt. 

If you’re considering an installment loan, monitoring your credit can be a good first step. You can use CreditWise from Capital One to monitor your credit health. It’s free to everyone, not just Capital One customers. And using it won’t hurt your credit scores. You can also use the CreditWise Simulator to see how borrowing money might affect your credit.