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Loans updated: 05-27-2019
An installment loan is one of the simplest and most common types of loan. The borrower completes an approval process and is then given an agreed-upon sum of money, which is paid back over a series of payments on a set schedule. These payments are usually equal in amount, paid at regularly scheduled intervals, and include both the principal and the interest. A mortgage, for example, is a type of long term installment loan used to pay for real estate. A car loan is used to purchase a vehicle or other means of transportation. However, there are installment loans that cover smaller purchases and have fewer scheduled payments, such as a personal loan.
Here is a classic example of an installment loan: Steven and Mary wish to buy a new lawnmower but cannot afford the full price for the one they want. They go to a local lender and apply for an installment loan. After being approved, they receive a loan of $2000 and agree to pay it off over the next two years. The interest on this loan comes to $400, making the total loan amount $2400. They pay $200 a month for two years, at which point the lawnmower is completely paid off. They will have the lawnmower that they wanted even though they did not have the cash to pay for it upfront. If they met all of the terms of their loan, Steven and Mary also will have improved their credit rating. They will be more likely to be approved the next time they need a loan because they have shown they are trustworthy.
Installment loans are extremely common. When most people refer to getting a loan, this is the type that they are usually referencing. Because they are so common, many people incorrectly assume that they understand this type of loan and what it requires. However, there are many legal and financial complexities that are not well understood. It is important to know the details about a loan before signing on the dotted line.
The Basics of Installment Loans
Because the definition of an installment loan is so broad, there are many different variations. These will vary according to the lender and the borrower as well as what is being bought and how much is being borrowed. Each loan will have its own unique features, including:
- The purpose of the loan. People can get installment loans for a variety of purposes. Mortgages are a type used to purchase real estate. Car loans are also a common kind of installment loan. Business loans often are paid in regular installments and can be used to start or expand a business. Personal loans are usually this type of loan as well, and can be used to cover a wide variety of expenses. Debt consolidation loans also are often installment loans. These allow people with high amounts of debt to pay off all of that debt at once and instead have just a single monthly payment.
- Interest rate. This affects the total amount being borrowed as well as the amount of the payments. Different institutions offer different interest rates. Interest rates will also be affected by the borrower's credit history, down payment, collateral, and other variables. The federal government sets the minimum interest rate, but most lenders charge more than this bare minimum.
- How interest is calculated and accrued. Most installment loans have a fixed interest rate that is determined and agreed upon before the loan is made. However, mortgages often have variable interest that changes according to national interest rates. In this type of installment loan, the amount of the payment may vary according to changes in interest rate. Most installment loans do not have a variable interest rate or changing payment.
- Whether collateral is required. In some types of installment loan, the item being purchased with the borrowed money is its own collateral. Mortgages and car loans are both examples of a collateralized loan. If the borrower does not follow the terms of the loan, including failure to remit payment as agreed, the collateral will be seized by the lender. This is also known as repossession. Other types of installment loan, such as a personal loan, may or may not ask for collateral. People with high credit ratings are more likely to qualify for a loan without any collateral.
- The length of the loan. This is also called the loan 'term'. In general, large amounts of money will require longer periods of time to repay. For example, a home mortgage often has a thirty-year term, while a car loan will have a shorter term such as five years. Even smaller loans may be paid off in a few years or even just months.
- Down payment. Some installment loans require a down payment. It is a good idea to save for this down payment whenever possible. A larger down payment will reduce the amount of money that is borrowed, thereby reducing both the payments and the interest. Saving for a down payment also shows fiscal responsibility, that the borrower is capable of acting responsibly with money and has extra money in their budget for the loan payments.
- Proof of income, such as last year's tax return and/or paycheck stubs
- Proof of collateral if you are offering this
- Proof of the amount of your large bills, such as rent or house payment
- Proof of need, namely the reason you are requesting the loan
- Clean up your credit record. There may be easy ways to improve your credit score quickly, such as closing unused accounts.
- Pay off or consolidate other debts. Some companies consider the debt to income ratio very important in qualifying for a loan.
- Save for a higher down payment. This will show financial responsibility and also decrease the amount that you need to borrow. However, it is not a short term solution for people who need immediate loans.
- Reduce other bills. Having lower rent or other commitments will leave more money for loan repayment.
- Offer collateral, such as the title to a car.
- Ask a loved one with better credit to cosign on the loan.
- Ask for a lesser amount of loan.
- Apply with an institution that has fewer restrictions. Banks are very stringent, but other companies may be more forgiving.
- Apply for a different kind of loan. You may qualify for a loan if it is spread over a longer length of time or if you are willing to pay a higher interest rate.
These are the most common differences between installment loans, but there are other details that will vary between loans and lenders. The loan process can be confusing to people who are unfamiliar with all of these variables. It is important to ask the lender about the terms of the loans they offer and to read all of the paperwork thoroughly, including all of the fine print. Familiarize yourself with the process and look up any words or phrases you do not completely understand. In some cases, the terms can be negotiated or changed before the paperwork is signed, so many people get the type of installment loan that is right for them.
An installment loan is an important financial step. For many people, it is the only way they can afford to purchase a home or a car. Getting one's first loan is often a rite of passage, a sign that they are an adult and are now capable of being responsible and stable. Paying off the loan according to its terms will improve a person's credit and help him or her to continue to build financial assets. Failing to follow the terms of the loan can be destructive to credit. It may even lead to losing the collateral and/or the item purchased as well as all of the money already paid toward the loan.
Installment Loans: The Process
Getting approved for an installment loan usually requires a short but intensive process. While the exact requirements vary by lender, most applications will follow roughly the following steps.
1. Determine the budget. It is important for borrowers to go into any loan application process knowing exactly how much they can afford to pay. Many institutions have recommendations and guidelines to help determine this. For instance, many mortgage lenders prefer for housing expenses to comprise no more than a quarter of a household's gross income. Auto lenders want car payments to be an even smaller fraction. If a person has extenuating circumstances, such as high medical bills, he or she also may need to have a lower monthly payment. Examine your financial situation and be realistic. Once a reasonable monthly budget has been determined, loan calculators such as this one can be used to see exactly how much can be borrowed while staying within a person's means.
2. Prepare to apply. Most successful borrowers take time to prepare before applying for a loan. This process includes cleaning up the credit record, closing unused credit accounts, paying off small debts, and otherwise improving one's financial picture as it appears on paper. This is more important before applying for large loans but can also be beneficial for people seeking a smaller amount.
3. Choose an institution to apply through. Installment loans can be sought through banks, mortgage lenders, and even smaller institutions such as car companies and payday loan companies. These places will all have different terms and different requirements, so be sure to choose wisely. Research which ones are the best for your situation. Most companies will tell prospective borrowers the minimum required credit score and other important details. Local places are often an ideal option because borrowers can meet with lenders in person and discuss their needs and the conditions of the loan.
4. Gather paperwork. Loan companies each require a slightly different set of papers. Most will want to see the following items:
5. Complete the application process. Many lending companies have employees who help potential borrowers to complete the necessary paperwork and ensure that they have all of the documents needed to apply. These people can give applicants advice on how to qualify for the loan they need. They also will make sure that all of the paperwork is in order and signed before completing the application.
Once you have passed these steps, it is only a matter of waiting for approval or denial. The lender should be able to give you an idea of when to expect this news. Some companies even offer instant approval to those who qualify. While this may seem like a complicated process, it can happen very quickly. Some companies will help you to complete the process in as little as a day.
What Happens When a Person Is Denied?
It is not unusual for an installment loan to be denied. This does not mean that the borrower will not be able to get a loan of any kind. It means that they do not qualify for that particular loan with that company. Many people are denied and then re-apply after having changed either their circumstances or the terms of the loan they want. They also may have to switch lending companies to find one where they qualify. Here are a few ways to increase your chances of having a successful application after an initial denial.
You do not have to wait for a denial to do any of these things. In fact, they are all highly suggested for anyone about to begin the loan application process for the first time. Performing these tasks before applying for an installment loan can improve both your chances of being approved and your interest rate for the loan. However, many people are approved for loans even with poor credit or other dings on their record.
Advantages of Installment Loans
There are several advantages to installment loans that make them one of the most popular and common loan types. The major benefits of this type of loan include:
- Consumers can buy large ticket items such as cars and houses without having to save the full amount over decades.
- Borrowers get a lump sum when the loan is approved rather than smaller payments over time.
- If the terms of the loan are met, installment loans can help build good credit.
- The fixed payments and fixed intervals allow people to budget precisely and know what they can afford before agreeing to the loan.
- They cost less than payday loans, pawn shops, and other means of getting loans without already having assets.
- They can be paid off over a longer period of time, allowing for more affordable payments.
- Installment loans are sometimes faster to apply for than many other types of loan, often taking as little as a few hours for the entire process.
- Most people can get this kind of loan without a perfect credit record, high income, or high amounts of assets.
- They usually have lower interest rates and loan fees than payday loans and other ways of quickly acquiring money.
- Many of these loans do not require collateral except for the item or items being purchased with the loan.
- There is often less hassle than applying for other types of loans, including less paperwork to be completed.
- Installment loans are legal in states and regions that have made payday loans illegal.
- They can often be paid off early if the borrower finds himself or herself able to do so.
These factors are why so many people turn to installment loans to get funding for large expenses. A person with decent credit who wishes to invest in a large item can easily apply for and often be approved for the money they need. Even people with less than perfect records can often get what they need.
Disadvantages of Installment Loans
As with all types of lending, there are a few significant drawbacks to applying for an installment loan. These include:
- The interest rate is higher than some other types of loan.
- There may be origination fees and other costs to procure them.
- Qualification for a loan requires documents such as proof of income.
- People with very low credit ratings or a recent bankruptcy may need to pay higher interest, find a cosigner, or provide collateral.
- Any purchases made with the funds may be repossessed if the borrower fails to make payments on time.
- Previous payments will not be returned if the borrower defaults on the loan.
- Some lenders may offer unreasonable terms, particularly to people with poor credit records or low income.
- There are several methods of calculating interest, which can be confusing to many people.
- The conditions cannot be changed once the loan is signed, even if the borrower's financial situation changes. Some lenders allow refinancing, but this requires taking out an entirely new loan.
Despite these drawbacks, installment loans are often the best option and even the only option for people who need to borrow money to cover large purchases or other expenses. Many of these disadvantages can be dealt with through good planning or negotiation. It is important to talk to the lender and agree upon the terms of the loan completely before signing.
How Do Repayments Work on an Installment Loan?
One of the major benefits of installment loans is that the repayment plan is clear and will not change. The loan paperwork will state how often payments are to be made and what amount is expected. As long as a borrower follows their schedule, they will likely have no problems.
While this type of loans is very straightforward to repay, there are several variations in repayment between different installment loans. Some lenders allow people to pay the loan off more quickly by making more frequent or larger payments without a penalty, while others have fees for early repayment. Some installment loans calculate interest differently, although almost all lenders will tell you the total amount upfront regardless of the interest accrual method.
Some lenders will allow borrowers to schedule payments so they are automatically paid from the primary bank account, while others require that you remember to send a check or pay online. It is important for borrowers to know how they will be paying, particularly if they have a history of forgetting to pay bills or do not have a traditional checking account. In addition, some lenders are stricter than others about grace periods for late payments. Some will add late fees or take steps to repossess the purchased item if a payment is even a few days late.
In many cases, lenders can tailor the loan to meet the needs of the borrowers. People can get lower payments by extending their loan repayment period or otherwise modifying the terms. Some lenders will even allow you to refinance if your financial situation changes so that you struggle to pay the agreed-upon amount. Ask about all of the options for repayment before signing any kind of loan paperwork so you can choose the best one for your situation.
How Much Will It Cost You to Borrow?
The amount that it costs to borrow will depend on several factors including the interest rate and lending fees. Interest can be accrued in a variety of ways but there are three common ones you are likely to encounter in an installment loan, which are:
- Flat fee. In this type of interest accrual, you simply pay a fee to borrow the money. This is very unusual in the lending world but still used occasionally with smaller lenders.
- Simple interest, which is calculated upfront on the amount of loan taken out over the years it will be paid off. This can be calculated by multiplying the amount of loan by the length of repayment by the number of years you will be making payments. For instance, if you pay 4% simple interest on a $100 loan paid over 1 year, you will pay $4 in interest. If the loan is paid instead over two years, you will pay $8 total.
- Compound interest. In this type of interest, interest is re-calculated for each year of the loan. If you borrow $100 at the same 4% annual interest rate for this type of loan and pay it over 2 years, you will pay $4 in interest the first year and then $2 on the remaining $50 the second year.
How much interest will you be asked to pay? This depends on several factors. People with good credit scores or a high down payment generally pay less interest because they are a better risk. In addition, loans with shorter repayment periods usually have higher interest. Interest rates also vary according to federal rates as well as how the country is doing economically.
Most lenders prefer compound interest for loans that will be paid off over the span of more than a year as they can then get fair returns on the actual amount owed at any time. The way interest is calculated is usually not negotiable. Each lender has their own preferred method. If you prefer a different method, you will have to find a different lender.
In addition to interest, there are other fees that may be charged for this type of loan. Most lenders charge some of these fees, which include:
- Origination fees. This is the cost to apply for, approve, and set up the loan.
- Disbursement fees. These fees cover the cost of giving you the actual check for the loan.
- Refinancing fees. If you cannot repay the loan according to its terms and are offered the option of refinancing, you will generally have to pay for the privilege.
- Late fees. Many lenders charge a set amount for each time you are late. It is important to know these so you can pay them promptly when needed and avoid repossession or hits on your credit rating.
There may be other fees involved in an installment loan as well. Loan fees and the way interest is accrued both can make a substantial difference in the amount that you ultimately have to pay back. All lenders should be upfront about how they calculate interest and how much borrowers ultimately will have to pay over the course of a loan.
Am I Eligible for an Installment Loan?
Every lender has their own requirements. Most will want proof that you have employment or another steady source of income that will allow you to make your monthly payments, such as paycheck stubs or bank statements. Child support, disability benefits, and almost any steady income can qualify. People applying for a loan generally need to be at least 18 years old and live in the state in which they are applying. Lenders will need proof of your identity, such as a government-issued photo ID or driver's license. Some also require a social security number, proof of address, or other documents. It is also common for lenders to ask to see proof of your other bills, such as rent, to ensure you will be able to make monthly payments on your loan.
Many lenders have other regulations as well. Many of them have a cut off for credit rating and will not lend to people who are below that number. Some will not lend to people who are currently filing bankruptcy or who plan to do so in the near future. Because there are strict federal regulations on lending to service members, some will not lend to regular or reserve members of the armed forces, nor to their dependents. Lenders that use automatic withdrawal for payment may require that you have had a bank account for a set amount of time.
The acceptable documents for each of these clauses also vary by lending company. Contact the ones you are interested in if you have situations that might make it difficult to qualify for a loan.
These rules are not always written in stone. Some lenders are willing to be more lenient if you are willing to show more documentation and/or pay a higher interest rate. There is even "second chance" loan companies that specialize in helping people with poor credit or a history of bankruptcy to rebuild their credit.
Is an Installment Loan Right for You?
The answer to this question is very personal. Installment loans are an opportunity to build good credit while getting funds for things that you need or want. For many people, this is the only type of loan or credit that is available to them. However, these loans have drawbacks as well. In addition, some people may not qualify. Many people may benefit from this type of loan if they need money for a purchase that is otherwise out of their financial reach. It is important for each person to talk to a lender and to understand how the terms of the loan will impact his or her life.