What is an Installment Loan & How Does it Work

An installment loan is where the borrower receives a lump sum of money upfront and must repay it in equal installments with interest over a predetermined time frame.

Installments loans are used primarily to finance a significant purchase or expenditure, such as a vehicle or home renovation.

They’re also a popular tool for consolidating high-interest debt, paying off past-due bills, or funding a vacation.

How Does an Installment Loan Work?

An installment loan consists of four components: principal, interest rate, term, and payment frequency.

Principal

The principal is the amount of money you receive up front from your lender.

Depending on your loan’s conditions, you may have the freedom to spend the funds as you please.

Or, the contract may restrict you to a specific purchase, such as a vehicle.

The amount you can borrow typically ranges with some lenders offering loans up to $50,000 or more.

Interest Rate

You can expect to pay a fixed interest rate on most installment loans (though variable-rate options are available, too).

This means that the rate your lender assigns to you at the loan’s inception will remain the same for the term’s duration.

Installment loan interest rates vary considerably.

You can receive quotes anywhere from the prime rate at traditional banking institutions to 45% in the burgeoning alternative lending market.

Term

The term is the length of time over which you must repay the loan in full through regular payments.

Installment loan terms typically range from six months to five years.

Payment frequency

Installment loans offer borrowers various repayment schedules.

Depending on your terms and conditions, you can choose to contribute payments weekly, bi-weekly, semi-monthly, or monthly.

You can classify installment loans into secured and unsecured categories.

Below is an overview of the two.

Secured Installment Loans

A secured installment loan requires you to provide a personal asset as collateral to protect the lender.

If you default on your payment, your lender can legally assume ownership of the asset and sell it to cover their loss.

This attribute makes them suitable loan products for borrowers with substandard credit scores who would face difficulty qualifying for financing based on their creditworthiness alone.

Due to the extra protection courtesy of the asset, lenders are also more willing to offer borrowers low-interest rates on secured installment loans.

Unsecured Installment Loans

With an unsecured installment loan, you don’t need to contribute an asset as collateral to secure funding.

Lenders assume more risk by issuing an unsecured loan since there’s no asset backing the principal they can liquidate in the event of a default.

As a result, they charge borrowers higher rates to offset the added uncertainty.

Your approval for an unsecured installment loan hinges entirely on your lender’s perception of your ability to handle debt, which they form after evaluating your credit report.

Fact

Lenders are prohibited by federal law from charging interest rates on loans that exceed 60%.

How to Get an Installment Loan?

To qualify for an installment loan, you must, at a minimum:

  • Be at least 18 years old or the age of majority in your province or territory
  • Submit proof of Canadian citizenship or residency using government-issued identification
  • Provide a valid bank account number to receive the loan proceeds

Next, your lender will assess your financial situation to determine your eligibility.

This step may entail a credit check, verification of your income, and a review of your net worth and expenses.

They’ll conduct a hard inquiry on your credit report to review your experience with credit products.

They’re primarily concerned with your ability to make timely payments and honour your debt obligations (meaning no defaults).

Naturally, a steady flow of money is necessary to make regular payments, so your lender will request proof of income.

To satisfy this requirement, you can submit a T4 slip, recent pay stub, bank statements, or related documents.

In some cases, your lender may wish to evaluate your assets, liabilities, and monthly expenses to determine if you’re financially capable of servicing the loan.

How Do Installment Loans Affect Your Credit Score?

Taking on an installment loan will impact your credit score, either positively or negatively, depending on how you manage it.

An important aspect of your credit score is your payment history, which measures how punctual you are in repaying loaned funds.

On-time payments can boost your score, as it indicates you handle credit responsibly.

The longer you maintain a steady pace of on-time payments, the more improvement you can realize in your credit score.

Conversely, late payments impair your score, as it signals that you’re experiencing financial difficulty, increasing the likelihood of default.

Advantages of Using Installment Loans

For the right borrower, an installment loan can provide numerous benefits:

Fast Approval Times

Acquiring an installment loan is quick and straightforward, especially with an online lender.

You won’t be burdened with onerous paperwork, nor will you have to wait for weeks to get your money.

As long as you present a few key documents, you could obtain approval within hours to days and receive the funds in your bank account fairly quickly.

Flexible Terms and Repayment

Most installment loans accommodate a variety of repayment schedules and payment frequencies.

You can choose from different terms and make repayments weekly, bi-weekly, monthly, etc.

Depending on your lender’s policy, you may have the option of altering your payment frequency and applying a prepayment to save on interest costs as well as paying off your entire balance early.

Suitable for Low Credit Scores

Though certain financial institutions issue installment loans exclusively to borrowers with a solid credit standing, many lenders are willing to provide financing to those with subpar credit scores.

Couple getting an installment loan

Disadvantages of Using Installment Loans

Here are some drawbacks associated with installment loans:

High Interest Rates

Not all installment loans come cheap, especially if you seek financing in the alternative lending market.

Your lender may charge you a steep interest rate if you possess a low credit score and lack a reliable income.

Over time, these interest charges can substantially inflate your total debt obligations and become a financial burden.

Costly Fees

Installment loans may come with various fees, substantially increasing their total cost.

Some common ones you may encounter include origination fees, administrative fees, prepayment fees, and late fees.

Risk of Asset Seizure

If you’ve opted to get a secured installment loan, you always face the threat of your lender repossessing the asset you’ve designated as collateral.

Should I get an Installment Loan?

Whether applying for an installment loan is a prudent move or not will vary from borrower to borrower.

It depends on numerous factors such as the individual’s budget, lifestyle, credit score, income, etc.

Installment loans are a viable source of financing if you have a reliable income and a high credit score.

The reason is that you’ll experience little or no issues making timely payments, thus maintaining your credit standing.

You’ll also have greater access to funds at favourable interest rates and terms.

On the other hand, if you struggle financially, your income stream is erratic, and your credit is poor, an installment loan isn’t ideal.

In this scenario, you’ll likely only get approved for a high-interest loan, which may cause further financial hardship.

Frequently Asked Questions

  • What is an example of an installment loan?
  • What is the difference between an installment loan and a personal loan?

Mark is a freelance writer who specializes in covering personal finance topics related to investing, mortgages, credit cards, and more.

He is passionate about educating people on how the financial markets work and providing tips to help them better manage their money. Mark holds a bachelor’s degree in finance from the Northern Alberta Institute of Technology and has more than a decade of experience as an accountant.

Outside of writing and finance, he enjoys playing poker, going to the gym, composing music, and learning about digital marketing.