An installment loan, also often called a personal loan, is a versatile tool to pay for large purchases, both expected and unexpected.
To understand why installment loans are such a popular financial tool, consider these numbers: $36,843 and $35,676. Those are the average sticker prices for a new car and one year of tuition and fees at a private American university, respectively. At the same time, life is full of costly surprises—whether it be an emergency car repair or a close friend’s destination wedding.
The price tags for many of these purchases is well beyond the reach of many people—particularly those building careers and families. Installment loans put those important big-ticket items within reach. Though wildly popular, auto loans and student loans aren’t the only varieties of installment loans. And there are other ways that installment loans can benefit people.
For instance, an installment loan can be used to buy the furnishings that transform a new apartment or house into a home; to cover expenses in a medical emergency; or to foot the bill for that once-in-a-lifetime trip to go trekking in the Himalayas. But to benefit from them, it’s important to understand how they work and how to align them with your overall financial plan.
How Installment Loans Work
One of the virtues of installment loans is their simplicity—you borrow the money and then pay it back over a fixed period of time at a set interest rate. They allow the borrower to make monthly payments over a set time frame to cover the purchase, plus interest.
Installment loans differ from other popular forms of credit available. Credit cards, for example, are a type of revolving credit, which let you continue borrowing until you reach your credit card’s limit, unlike installment loans. Another difference: Instead of making the fixed monthly payment until an installment loan is paid off, credit cards allow borrowers to choose how much to repay each month. This can be a benefit in terms of flexibility, but it can also lead a cardholder to pay more in interest if they aren’t strategic about their payments.
Study the Terms and Conditions
Before deciding whether an installment loan is a good fit for any particular purchase, read the terms and conditions a lender offers. Because installment loans are often for dollar amounts that are larger than you can pay out of your checking or savings accounts, it’s important to know the interest rate being charged. Interest rates are generally determined based on your credit score, so if you’ve done a good job repaying credit cards and student loans, you’re more likely to receive a competitive rate.
In most cases, the interest rate will be fixed rather than variable. It can be easier to budget for a fixed payment than one subject to change each month. While interest rates are important, be sure to also pay attention to the amount of time you have to repay the loan, and whether or not there are any fees to initiate the loan, or for late payments.
When Should You Use an Installment Loan?
When to actually use an installment loan depends on a number of factors, starting with your priorities and necessities. If you live in a place where having a reliable car is vital for commuting to work and carting around young kids, it may make sense to seek out an installment loan with good terms and a competitive interest rate. The same can be said for other necessary purchases, including travel to care for a family member who falls sick or to pay for a critical home or auto repair.
For purchases like continuing education, travel or new electronics, consider the impact the repayment of the installment loan will have on your short- and long-term financial plans. One big benefit of installment loans is that it’s easy to make those calculations. Because you know how much the monthly payment will be, it’s relatively simple to calculate the financial impact on your short-term budget. It’s important to go through this exercise and be realistic about whether or not an added monthly expense is worth the benefits you’ll receive from the purchase.
Long-Term Thinking About Short-Term Loans
Deciding when to use an installment loan is also about the long-term. Young savers likely know the benefits of putting money in a 401(k) or other investments each month. The monthly payments on an installment loan may reduce how much money you invest. But you may decide that an installment loan to pay for a trip that won’t be possible once you have kids is more than worth it.
When to use installment loans depends on a wide range of factors, and on you. But what makes them such a powerful tool is that they provide you with one more option. You just have to decide when, how and whether or not to use it.
A former editor at Los Angeles magazine, Chris Warren's writing has appeared in publications ranging from Institutional Investor and Forbes to National Geographic Traveler, Oxford American and Greentech Media.
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