What is an Installment Loan?
You've probably heard about installment loans before, but do you really know what they are and how they work? Well, we are here to set the record straight and provide all the need-to-know information. Let's start at the beginning and define installment loans, so we have a clear understanding of what we're talking about.
An installment loan, as the name suggests, is a loan that is repaid over a set number of installments. In other words, there is a predetermined payment schedule that the borrower must follow in order to pay off the loan in full. The payment period varies based on the type of installment loan you are interested in, but there are normally at least two payments made towards the loan. The term of the loan can last as little as a few months to as long as 30 years. A 30-year installment loan is almost always a mortgage - a loan someone takes out in order to purchase a home.
Amortization for an Installment Loan
Installment loans typically follow an amortization schedule, meaning each payment covers the cost of both interest and principal. At the beginning of the loan, a greater amount of money is allocated to interest. At the end of the loan, almost the entire monthly payment is put toward the principal. Once both the principal amount and interest are paid off, the installment loan is paid in full and no more payments are required.
In a sense, the structure of installment loans provides a security measure for the lender, because he or she knows the loan will be repaid over a specified amount of time. If the borrower fails to pay in the allotted time, interest will accrue and the borrower will be required to pay a higher total amount for the loan.
Installment loans are a great solution for businesses and individuals who need money to purchase a large item or service. They are a convenient way to pay for costly items such as a home or car in more manageable chunks over time. After all, not many people have thousands upon thousands of dollars to use however they please, so installment loans can be a convenient way to borrow money.
In many cases, installment loans are secured via a borrower's personal asset or by the item purchased. For instance, if you need some money to afford a surprise home repair, you can use the title of your car as collateral and receive a title loan, a type of installment loan. You agree to repay the loan in equal monthly installments and at the end of the payment period, your title is returned. You get to keep your car throughout the duration of the loan.
Collateral-based Installment Loan
Collateral-based installment loans are particularly helpful for low-income or unbanked Americans who are looking for a short-term financial solution. Unlike a mortgage loan that can last several decades, title loans and other collateral-based loans typically last less than a year. As mentioned before, there is an opportunity for installment loans to be renewed or rolled over if not paid in full within the specified time period, so borrowers need to be on the lookout for inflated interest rates - at times, rates can reach triple-digit levels.
Now that you know what installment loans are, let's see how they work by using a real-life example. If you take out a loan for $2,000 at an interest rate of 10% to be paid back in 12 monthly installments, how much would you end up paying each month? Well, with interest, the total cost of your installment loan would be $2,200, because you would need to pay $200 in interest. In order to pay $2,200 over the course of 12 months, you're looking at monthly payments of $183.33. To summarize, you would make 12 monthly payments of $183.33 each. Each payment would comprise a portion of principal and a portion of interest.
As you can see, installment loans can be a great way to pay off a large sum of money in bite-size pieces. Since you know what your payment will be each month, you can budget accordingly and avoid getting into additional financial trouble due to your loan. As is the case with any type of financial decision, be sure to weigh your options and determine whether an installment loan is the right choice for your particular needs.