What is an Installment Loan - And How is It Different from Revolving Credit?

Whether it’s student loans or a mortgage, you likely have some form of outstanding debt. Chances are, it’s in the form of an installment loan since nearly 92% of U.S. consumer debt is installment loans.

Despite how common these loans are, you may not be sure how they work or how they differ from other forms of credit. So what is an installment loan? It’s a loan you pay back over a set period with regularly scheduled payments — also known as installments — along with interest.

If you’re thinking about applying for an installment loan, here's what you may need to know first.

What is an installment loan?

An installment loan is a loan with a fixed amount. For instance, a $5,000 personal loan or a $10,000 auto loan. If you apply for an installment loan and it’s approved, your lender will disburse the funds as a lump sum to you or a third party, in the case of home and auto loans.

Installment loans also have fixed repayment periods. Depending on the type of loan, your loan term could be anywhere from three months to 30 years. When you get an installment loan, you’ll generally be required to make monthly payments until it’s paid off. Your monthly payments will include a portion of your principal, plus interest. Installment loans often have fixed interest rates, though some types of installment loans — such as mortgages or private student loans — also offer variable rates.

Installment loans can be secured or unsecured. Secured loans require you to use your property as collateral, while unsecured loans don’t require collateral.

What are the different types of installment loans?

You may not realize it, but you might already have an installment loan. They come in many different forms and can vary in interest rates and repayment terms. These are some common types of installment loans:

Mortgage loan

A mortgage loan, also known as a home loan, is what you’d use to finance the purchase of a new home. Issued by banks, credit unions, and specialty lenders, mortgages generally have loan terms as long as 30 years and fixed or adjustable interest rates. Mortgages are a form of secured loan, with your home serving as collateral for the loan. This means that if you default on your mortgage, your lender could start the foreclosure process.

Mortgages are installment loans because they have a set repayment term, and they require monthly payments. A traditional mortgage differs from some other installment loans in that the money doesn’t go directly to you. Instead, your lender will disburse the loan amount to a closing agent when you close on your new home. Those funds are then distributed to the home seller.

Personal loan

Personal loans can be used for debt consolidation, home repairs, medical expenses, veterinarian bills, or any other expense you want to cover. There are both secured and unsecured personal loans, but unsecured loans are the most common.

With a personal loan, you receive your requested loan amount all at once. These loans typically have fixed interest rates. With personal loans, you’ll have a set monthly payment, and repayment terms often range from three months to seven years. By comparing rates and terms, you can find the best personal loans for your situation.

Like other installment loans, you'll know exactly when your loan needs to be paid off; the lender will include the expected payoff date in your loan documents.

Auto loan

When you purchase a car with an auto loan, your vehicle serves as collateral for the loan. Auto loans typically have fixed interest rates. And whether you get financing through a dealership or financial institution, your auto loan will also have a set repayment term — usually two to eight years — and you’ll typically have fixed monthly payments.

Home equity loan

With a home equity loan, you use your house’s equity — the result of subtracting what you owe on your mortgage from the home’s current value — to get money for home repairs, your child’s education, or even a vacation. Many lenders require that you have at least 15%-20% equity in your home to be eligible for a home equity loan.

Home equity loans are installment loans in that they give you an upfront sum of cash after approval, and they’re repaid over a set period with monthly payments. Repayment terms can range but are generally between five and 30 years, and interest rates are generally fixed. Your home serves as collateral, securing the loan.

Credit-builder loan

A credit-builder loan is a tool you can use to build your credit if you have no credit or poor credit. Offered by some banks, credit unions, and online lenders, a credit builder loan is for a lump sum of cash. These are generally fixed interest rate loans with short repayment terms, often ranging between six to 24 months.

If you’re approved for a credit-builder loan, the lender will set aside the loan amount for you in a secure account rather than giving it to you directly. You'll then make monthly payments and once the loan is paid off, the lender will release the loan proceeds from the account to you.

Credit-builder loans work by helping you establish a payment history. The lender reports your payments to the credit bureaus as you make payments over the loan’s term. If you make all of your payments on time, the loan could help you improve your credit score.

Student loan

Both federal and private student loans are types of installment loans. Federal student loans have fixed interest rates, but private student loans can have fixed or variable interest rates and change over time.

Student loans are installment loans because you’ll have a fixed loan term and make regular monthly payments. Repayment periods for student loans often range from 10 to 25 years.

Installment loans vs. revolving credit

When it comes to borrowing money, it’s important to understand the difference between installment credit and revolving credit. With installment loans, you generally borrow a set amount of money and have a fixed loan term.

By contrast, revolving credit can be used on an ongoing basis, meaning you can spend up to your credit limit, repay the amount, and then spend up to the limit again. Credit cards and home equity lines of credit (HELOCs) are examples of revolving credit.

Revolving forms of credit differ from installment loans in several key ways:

• Monthly payments: With fixed-rate installment loans, you have a set monthly loan payment that won’t change over time. Payments on variable-rate installment loans can change slightly as interest rates increase or decrease. However, with revolving credit accounts, your monthly payments can vary widely over time based on your spending.
• Interest rates: In general, installment loans have lower interest rates than revolving lines of credit. For example, the average interest rate on all credit card accounts that assess interest was 16.30% in May 2021. That’s significantly higher than the 9.58% average for personal loans or the 5.28% average for car loans with a 48-month term.
• Repayment terms: Installment loans have a fixed repayment term. For example, with mortgage loans, repayment terms are generally up to 30 years. With certain types of revolving credit, like credit cards, there is no set repayment term. You can simply pay off your balance each month and keep spending up to your credit limit, as long as your account is in good standing.

Installment loans aren’t necessarily better than revolving credit; they just have a different structure. Installment loans could be a good choice if you have a one-time project or expense, and you know exactly how much it costs. You’ll get the money you need all at once and can pay it back over months or years.

Revolving credit could be a good option if you have ongoing expenses, such as a credit card that you use for all of your grocery shopping or utility bills. You can use that card for whatever you want for years, tapping into your credit again and again as you pay off your monthly balance.

How an installment loan impacts your credit score

An installment loan could still impact your FICO credit score in several ways:

• Credit inquiry: When you apply for a loan, the lender will review your loan application and pull your credit report, which results in a hard credit inquiry. A hard credit inquiry may cause a slight dip in your credit score, as new credit accounts for 10% of your FICO score.
• Credit mix: Your credit mix, which accounts for 10% of your score, is the combination of the different types of credit you have. For example, a home loan, retail credit card, and installment loan. A good credit mix could result in a better FICO score, ​​so you might see your score improve when you take out an installment loan, depending on your situation.
• Length of credit: Lenders like to see that you’ve been handling credit responsibly for some time. Opening a new account may lower the average age of your accounts slightly, which could cause your credit score to drop a little. The length of your credit history accounts for 15% of your FICO score.
• Payment history: On-time payments are essential; your payment history impacts 35% of your score. As you repay your loan and make your payments by their due dates, the lender will report your payment activity to the credit bureaus. By keeping your account current, your payments on the installment loan may help boost your credit over time.
• Credit utilization: Because installment loans aren’t revolving credit, they won’t factor into your credit utilization ratio, which accounts for 30% of your FICO score. However, using an installment loan to consolidate high-interest revolving debt is a popular strategy. For instance, a borrower might use a personal loan to consolidate credit card debt. By consolidating revolving credit, you could lower your credit utilization and improve your credit score.

FAQs

Bottom line

What is an installment loan? It’s a tool you can use to finance major expenses, such as a home or car purchase, college tuition, or another type of expense. There are many different types of installment loans, but they generally have a couple of things in common. With these loan options, borrowers get lump-sum loan amounts and set repayment terms.