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Personal loan use has steadily increased in America for the last decade. In recent years, getting a loan has become much easier, and many Americans have seized the opportunity. The total amount of personal debt in 2021 was up $436.1 billion. This total represented an overall increase of more than $30 billion since 2019.

Personal loans have a large variety of potential uses. Many people will seek personal loan options to help them make a big purchase, such as a house or a new car. Some will use them to cover education costs or help pay off other debts with higher interest rates. Others might simply use a personal loan to fund a dream wedding or once-in-a-lifetime vacation.

Starting a new business is another common reason someone might take out a personal loan. Securing funding for a business can be very difficult when you’re first starting. The company won’t have established credit and will be too new for a lender to provide funding. Using a personal loan to finance a new business isn’t the only option for business owners, but it’s often the easiest one for most people.

What is an installment loan?

The majority of personal loans are categorized as installment loans. An installment loan is a close-ended credit account that you pay off over a predetermined period of time. You receive the balance of money upfront and slowly pay it back over time with a fixed interest rate.

Each payment is divided into an identical amount paid during a regularly scheduled installment (hence the name). The account is closed when the total balance is paid off, and the matter is considered settled.

Let’s say you took out a personal loan for $5,000 with an interest rate of 8% and a term of three years (36 months). You would make 36 payments of $156.68 for the next three years. After the 36th payment, the initial $5,000 would be repaid and $640.55 in accrued interest. The monthly payments would stop, and your credit score would be updated.

What are the different types of installment loans?

Not all installment loans are the same. Although the repayment period typically follows the same pattern, plenty of characteristics differentiate these loans. Here are six examples of the most common types of installment loans and their unique attributes:

Personal

A personal installment loan is one of the broadest and most loosely defined types of installment loan. The money typically has no designated purpose and can be used on whatever the borrower wants.

The money is paid in a single lump with an agreed-upon repayment term and fixed interest rate. The repayments are divided into equal monthly payments and will continue until the balance is settled.

Student

There are two types of student loans available: private and federal. Both are installment loans, but federal loans are typically much more lenient. In most cases, student loan payments are deferred until the student graduates or drops out of college.

Full-time students would find it to be virtually impossible to afford to pay back their loans. The interest rates are fixed, and the terms can last anywhere from a few years to a few decades.

Auto

Installment loans are very commonly used to pay for cars. Usually, you’ll need to make a down payment on a car (or apply the trade-in value of your current car) and cover the rest with a loan. The new car will be used as collateral to secure the loan, which means it can be repossessed if you fail to make payments.

The time frame for an auto loan is usually five years or less, and the interest rate will vary depending on your credit history.

Mortgage

The overwhelming majority of people can’t afford to purchase a house in cash. They’ll need to take out a mortgage to buy a new home. A mortgage operates like an auto loan, except the repayment terms are much longer, and the house is used as collateral.

Most mortgages come with repayment terms lasting 10, 20, or 30 years. The interest rates of a mortgage are typically meager because of these long repayment terms.

No Credit Check

In most cases, a lender will be adamant about checking your credit score before providing you with a loan. A no credit check loan, sometimes called a payday loan, forgo the traditional credit check and grants you the funding anyway.

These loans typically come with a limit of a few hundred dollars, extremely high-interest rates, and a concise repayment term. However, no credit check loans can be a good option if you have a bad credit history or a difficult financial situation.

Buy Now Pay Later

A buy now pay later loan, also known as point of sale financing, is commonly offered to shoppers by retailers. You can spread out payments for an item over a few installments instead of paying all of it upfront. Depending on the offer, these payments can last for a few weeks or a few years.

These loans are made available with zero interest and very lenient approval requirements. Be wary of these loans as they can tempt you into spending more than you can afford and overspending on your purchase.

How do you apply for an installment loan?

You can apply for an installment loan at most banks, credit unions, or traditional financial institutions. There are also plenty of online lenders that are willing to grant installment loans. The exact process will vary depending on the lender you choose and the loan type you seek.

However, a few similarities will generally apply. For example, you’ll most likely be required to possess the following items:

  • Personal identification such as a driver’s license, passport, or government-issued state ID
  • Proof of income such as pay stubs or bank statements
  • Social Security Card
  • Personal banking information

The lender will also want to know about your credit report and other debts. In some cases, the lender might perform a hard inquiry into your credit which can lower your score by a few points. Your FICO score will be a critical determining factor in whether your loan application is accepted. It will also play a significant role in determining your overall interest rate. It’s best to ensure your credit is in great shape before applying.

What are the pros and cons of an installment loan?

Installment agreements are one of the best options for people that need money now and can afford to pay it back later. However, a few potential issues can arise with an installment loan. You should be aware of the pros and cons before you look into taking out an installment loan.

The pros

  • Consistent payment schedule. The repayment schedule is firmly established and agreed upon before seeing the first dollar from your loan. You’ll know exactly how much each monthly payment will be and how many payments you’ll make.
  • Helps your credit. Repaying an installment loan on time is an excellent way to build up your credit. Establishing a history of paying off your debts will show future lenders that you’re trustworthy.
  • Get the money quickly. Installment loans are all built around giving the borrower a large sum of money upfront. Once the agreement is made, you’ll be given the money to immediately fund your purchase, which can be helpful for large purchases.
  • Potential to refinance. Depending on how long your loan term lasts, your credit score might improve, or the average interest rate will fall. It’s possible to refinance your original loan, which could lower your monthly payment or trim a few monthly payments off of your schedule.

The cons

  • It’s a time deal. The only money that you’ll ever get is received upfront. If you need additional funding for whatever reason, you’ll need to take out an entirely new loan with new terms.
  • Long commitment. A few installment loans are designed for the short term, but most of them last several years. You might be paying off your installment loan for the next 30 years.
  • Good credit is essential. The interest rate of an installment loan primarily revolves around your credit score. You could pay more interest if you don’t have a good to excellent credit rating.
  • Interest adds up. The claim that you pay on an installment loan can be breathtaking when you calculate it. Even with a favorable interest rate, you’ll still end up paying a considerable amount of money over the life of your loan.
  • Payments are locked in. The payment schedule is established and agreed upon upfront. You’ll still need to make your monthly payments even if you run into tough times financially.

 

Installment loans are helpful but can be costly

Taking out an installment loan is one of the best ways to get a large sum of money in a small amount of time. The problem is that you’ll have to repay that balance over time, along with interest. Depending on your credit, the interest rate could be cartoonishly high. You might end up paying a lot to take out your loan.

You can best try to improve your credit as much as possible before taking out your loan. It’s not always an option as your financial issue might not give you the necessary time. However, it’s essential to try as much as you can. It could be the difference between paying a few hundred dollars in interest or a few thousand.

Information provided on Entrepreneur Guide is for educational purposes only. Your financial situation is unique and the products and services we review may not be right for your circumstances. We do not offer financial advice, advisory or brokerage services, we do not recommend or advise individuals to buy or sell particular stocks or securities. Performance information may have changed since the time of publication. Past performance is not indicative of future results

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