Borrowing money can feel simple right up until the fine print starts throwing terms at you, such as “APR,” “loan term,” “principal” and “interest.” Suddenly, what seemed straightforward starts feeling like a pop quiz you didn’t study for.
Let’s learn more about what an installment loan is, how repayment works and how types of installment loans differ from each other.
What Is an Installment Loan?
An installment loan is a loan you repay in set amounts over time. Instead of borrowing money and paying it back whenever you feel like it, you make scheduled payments, usually monthly, until the balance is gone.
Installment loans are structured and have a clear repayment schedule. They also tend to have:
- Fixed payments: You usually pay the same amount each month, making budgeting a little easier.
- Set term length: The loan has a defined repayment period, such as 12, 36 or 60 months.
- Principal and interest: Part of each payment goes to the principal, which is the amount borrowed. Another part goes to interest, which is the price of borrowing the money.
- Predictable payoff date: Because the payment schedule is set, you generally know when the loan must be paid off.
Depending on the type of loan you have, it may be secured or unsecured.
A secured installment loan is backed by collateral, which the lender can seize if the borrower doesn’t repay the loan. A car loan is a common example; the car serves as collateral for the debt.
An unsecured installment loan doesn’t require collateral. A personal loan typically falls into this category.
How Does Repayment Work on an Installment Loan?
Each installment you pay slowly chips away at your total balance. With most installment loans, you:
- Make fixed monthly payments
- Pay over a set term (such as two to five years, but sometimes longer)
- See each payment split between principal and interest
Know Your APR
APR stands for annual percentage rate. This is the total yearly cost of borrowing money, including interest and fees. A higher APR means you’ll pay more over time.
If you’re comparing two different installment loans, look at the APR. The loans might have similar terms, but different APRs can mean very different total costs.
Understand Amortization
“Amortization” sounds like a fancy financial term, but all it means is that your payments are split up in different ways over time.
With amortization, a larger portion of your payment is applied to interest at the beginning of the loan. Later on, more of your payment goes toward the actual principal.
So, even though your payment amount may stay the same, how it’s applied changes over time. It’s the reason why your total debt load may not seem to budge much at first.
Calculate the Total Cost of Borrowing
One of the most important parts of repayment is understanding the total cost of the loan, not just the amount you borrowed.
Let’s say you borrow $5,000 with a three-year repayment term and a 12% APR. Your monthly payment would be about $166.
Over 36 months, you’d pay back roughly $5,976 in total. That means borrowing $5,000 actually costs you nearly $976 extra in interest charges over the life of the loan.
The longer your repayment term and the higher your interest rate, the more expensive the loan becomes overall.
What Counts as Installment Debt?
Installment debt is simply another term for an installment loan. It applies to any debt with a fixed repayment plan, a set timeline and regular payments. It includes things such as:
- Personal loans
- Auto loans
- Mortgages
- Student loans
Unlike some other types of debt, installment loans don’t stay open forever. Once you’ve made all payments, the account is usually marked as closed.
Revolving Debt Is Different
At this point, you’re probably realizing that a lot of the most common types of loans are installment loans. But not all loans fall into this category.
Revolving debt, like credit cards, is different. With this type of debt, you borrow up to a credit limit, and the balance fluctuates as you use it. There’s no real payoff date, aside from the date when you have to make minimum payments.
The downside is that your revolving debt balances can linger, especially if you only pay the minimum amounts due.
Move Forward With Confidence
If you’ve been wondering, “What is an installment loan and how does it work?” the answer is simple. You borrow a set amount of money and repay it through fixed monthly payments over time, like auto loans and student loans.
Before borrowing, compare offers from multiple lenders and look beyond the monthly payment to understand the loan’s total cost. Taking time to research your options can help you choose a loan that fits your budget and financial goals.
