Understanding different debt products and their functions may be confusing to consumers. There are several key differences between the two most common forms of debt: revolving (credit cards) and installment loans. Below is what you need to know, especially if you’re considering being more strategic with debt this year.
Installment loans differ from credit cards in two big ways: With installment loans you get all the money up front, and then you pay off the debt in fixed amounts over a fixed amount of time (known as the term of the loan). With revolving debt you can pay off an amount and later spend what you paid off again -- you constantly have access to the credit.
The most important things to determine before taking out an installment loan are how much you need to borrow and if the term or length of your repayment period will impact your monthly payment.
For example, a 60-month auto loan has a term of 60 months, meaning you’ll pay the loan back each month for the next five years.
Common types of installment loans
Installment loans are commonly used for big, fixed-price purchases that a credit card would likely not be able to cover. Think financial products such as mortgage loans, auto loans, student loans and personal loans.
Most auto loans offer a term length between 36 and 72 months, with the average auto loan term lasting 68 months, according to 2019 research from Value Penguin,
With auto loans, consumers often get the benefit of choosing if they’d like a longer repayment period (term), with a lower monthly payment and higher interest rate or a shorter term with a lower interest rate.
The most common terms for mortgage loans come in two varieties: the 15 or 30-year mortgage. As with auto loans, if you take on a 15-year mortgage you can get a lower interest rate, but your monthly payment will be substantially higher as you’re paying off the mortgage in half the time as a traditional 30-year loan.
Consumers can select a mortgage loan with a variable interest rate, but most opt for a fixed-rate loan, so they know exactly how much they’ll owe every month and know it won’t change depending on the interest rate environment.
Personal loans can be used for a variety of purposes like home repair or paying off debt, and they also come with fixed interest rates and term lengths.
Since these loans often do not require any type of collateral, however, they often come at much higher interest rates than other type of installment loans.
Pros and Cons to Installment Loans
Installment loans are very good for building a strong credit profile. For one, having installment loans in addition to credit cards impacts your mix of credit, which goes into factoring your overall score. Having regular, on-time payments each month also shows lenders a responsible payment history and builds your score.
There are very few “cons” to installment loans, especially since the average interest rate for this type of financial product (except for personal loans) is much lower than your average credit card interest rate. If you’re looking for drawbacks, an installment loan can make it difficult to access cash when you need it. For example, if you have a $5,000 installment loan, for example, and you pay off $1,000, you can’t access that $1,000 in a pinch.
It’s also worth noting that installment loans aren’t always a cheap option; many come with fees such as origination fees or penalty fees if you end up paying off the loan early. While often these fees are just the “cost of doing business” when applying for large loans, be sure to check with your lender what fees are involved before signing on the dotted line.