An installment loan is a basic consumer finance term. It is a type of closed-end credit that requires the borrower make payments in equal frequencies over a predefined period of time. Amounts are not required to be equal for each payment, although it is the most common structure.

The key concept to remember is that installment loans (1) end at a specific date (closed-end) and (2) are paid in even frequencies (usually months).

Student loans are the most common type of installment loan, followed by auto loans, mortgages, and personal loans.

Payment Structure

Installment loan payments are made in equal frequencies, with the option of early payments and renegotiation. In most cases, this means they are payable on the same day each month for the same amount.

Some installment loan categories also allow the borrower to make additional payments to decrease his/her balance more quickly. When the borrower makes early payments, the number of total payments decreases and the value of each payment remains constant, unless otherwise agreed.

If the additional payments do not total to a multiple of the original monthly payment, the final payment will be less than the standard payment value to eliminate the difference.

Renegotiation is the process of modifying the terms of an existing loan to make it more manageable for the borrower. This amounts to modifying the loan duration or interest, but not the loan amount.

Examples

A familiar example of installment loans is auto loans. Additional examples in the consumer space include:

Additional, potentially predatory examples include:

Closed-End, Not Open-End

Closed-end loans are those with a definite end-date, and open-end are those without an end date. Installment loans are closed-end, and credit cards are an example of open-end credit because they can be used indefinitely.

It's important to note that closed-end does not mean each payment is equal. It's entirely possible to have payments in different amounts.

Calculator

A typical installment loan has 3 inputs. The first is loan amount, which is the total principal of the loan distributed. The second is annual interest rate, which is applied at the periodic rate (i.e. monthly rate, or [annual rate] / [12] ).

The third is the number of periods in the loan, which is expressed in months for short installment loans and in years for larger, longer ones.

Application Process

The application process for installment loans is standardized. The borrower fills out a a digital or physical application complete with personal details for the purposes of (1) identifying and (2) evaluating the borrower, and submits it. The lender evaluates the borrower's creditworthiness and provides a response.

This structure is why creditworthiness is so important. Without it, the borrower has no means of justifying his/her reliability. There are limited healthy options, and when s/he has few options, predatory lenders usually take advantage with high interest and rigid repayment terms.

Creditworthiness

Creditworthiness for installment loans refers to the borrower's default risk based on his/her previous borrowing activity, including loans and revolving credit. Lenders must evaluate the risk that the borrower will repay the loan on time, and the borrower's credit profile is the basis for this.

A credit profile consists of a credit report and score. The report displays previous lending and expense management activities, including everything from credit card accounts with balance history month-over-month & any late payments, to loans with account closures up to 10 years old.

The credit score is a 3-digit number that summarizes the report in its own right.

When borrowers make late payments or default on a loan agreements, this information appears on their report and reflects in the credit score.

Lenders always use credit score as a starting place, but the material intensity of the debt type influences the depth of the investigation.

For example, a credit card lender may be content with score alone, but a mortgage lender will investigate the credit report in detail to pull out extraneous variables that may add nuance to the lending decision.

Borrowers with poor credit have options for rebuilding their credit. ThickCredit proposes an automated solution online, but borrowers can also investigate and do it entirely alone or lean on credit repair specialists to remove inaccuracies from reports.

Credit Builder Loans

An interesting nuance is the existence credit builder loans, which are installment loans structured in a specific way to accept borrowers whose creditworthiness is below average.

They use a combination of alternative creditworthiness metrics and savings-based collateral, and essentially require the principal amount be paid into a savings account, at the last period of which it is paid out. In other words, they work "backwards."

Key Features

The key features of installment loans are principal amount, interest, and duration. While there are many other terms that apply, most consumers only need to understand the nuances of these three.

Principal Amount

The principal of a loan is the base amount of money lent. It's the amount of money the lender transfers to the borrower at the start of the loan and the amount on which interest is calculated.

To be clear, this money is never given to the borrower. Another way to think about this concept is how it applies to taxes. You never pay taxes on money your borrow. However, if you default on a loan and do not pay it back, then the principal amount is considered an income on which your are taxed.

Interest

Interest is the cost of borrowing money. It is expressed as an annual percentage, which is then divided in most cases by 12 to get the periodic rate (or 365 for daily periodic rate). That amount is applied to the outstanding balance each period.

As a matter of simple multiplication, the relative amount of interest in each installment is higher at the start of the loan because the principal is higher. Towards the end of the loan, it represents a smaller portion of the payment.

For example, imagine a $1,000 loan at 1 % interest over 12 months. The monthly payment is $83.79 each month. However, the interest portion of the payment is $0.83 in month 1 and $0.07 in month 12.

The decreasing nature of interest is why it's to the borrower's advantage to make early payments, as this decreases the total amount of interest paid.

Duration

The duration of the loan is the number of days, months, or years installments last. Duration is a defining characteristic of installment loans, since it provides a predefined end date.

Payment Frequency

Installment loans are paid in equal frequencies, usually the same day each month. Additional payments are usually possible, but the core payment must be made. This is a defining characteristic because non-installment loans are closed-end, but they provide flexible payment frequencies.

Flexible Payment Amounts

Installment loans can allow for variable payment amounts. In most cases this manifests as additional payments. In the business-to-business space, however, it is possible to create a payment schedule with variable amounts month-over-month.