Installment Loan

What is an Installment Loan?

An installment loan refers to both commercial and personal loans that are extended to borrowers and that require regular payments. Each of the regular payments for the loan includes a portion of the principal amount, as well as a portion of the interest on the debt.

The amount of each scheduled payment is determined by several factors, such as the amount borrowed, interest on the loan, the terms of the loan, etc. Many installment loans come with fixed payments, which means that the amount that the borrower pays to finance the loan does not change over the duration of the loan.

Examples of installment loans include mortgage loans and auto loans. Apart from mortgage loans, which are variable-rate loans, most installment loans are fixed-rate loans. They are charged an interest rate that is unchanged for the term of the loan from the time of borrowing. Fixed-rate loans require borrowers to pay the same scheduled payments, allowing them to prepare in advance to make the future repayments towards the loan.

How to Obtain an Installment Loan?

When applying for an installment loan from a financial institution, the borrower first visits the credit department of the lender to discuss the terms of the loan, such as the loan amount, downpayment, loan duration, interest rates, purpose of the loan, etc.

Once the borrower is satisfied with the loan process, he/she is required to make a formal application by filling out the loan application form. The borrower is required to provide personal information (name, physical address, occupation, etc.), amount of loan requested, purpose of the loan, collateral provided, etc.

Once the loan application form is submitted to the bank, the lender initiates the loan evaluation process to determine the ability of the borrower to meet the loan obligations. The borrower may be required to provide additional information, such as recent financial statements, proof of ownership of the collateral, evidence of current cash flows, etc.

The lender may also ask for the borrower’s credit report to get information about the latter’s credit history for the past years. If the lender is satisfied that the borrower is creditworthy, the application will be approved, and the funds will be disbursed.

If the lender finds that the borrower presents a high risk, it can choose to reject the application or extend credit but at a high interest rate to compensate for the increased risk.

Types of Installment Loans

1. Auto loans

An auto loan is an installment loan that is borrowed in order to purchase a motor vehicle. Such loans usually come with a loan duration of 12 months to 60 months, or more, depending on the lender and the loan amount.

The lender provides the borrower an amount equivalent to the cost of the motor vehicle, and the borrower agrees to make monthly payments towards the loan until it is fully paid. The vehicle purchased using the funds becomes the collateral for the loan. If the borrower defaults on the payments, the collateral will be repossessed and sold to recover the loan amount.

2. Mortgages

A mortgage is a type of loan that is borrowed to purchase a house. It comes with maturity periods of 15 years to 30 years (or more) when the borrower is expected to make monthly repayments until the loan amount is fully repaid.

Most mortgages come with a fixed interest rate, where the future monthly principal and interest payments remain constant. An alternative to fixed interest rate mortgages is the adjustable-rate mortgage. In adjustable-rate mortgage loans, the interest rate is fixed for the initial term of the loan, after which the interest rate fluctuates with market interest rates.

3. Personal loans

A personal loan is a type of installment loan that borrowers use to pay off urgent expenses, such as college tuition, wedding costs, or medical expenses. The duration of a personal loan can be from 12 months to 60 months. Most personal loans charge a fixed interest, and borrowers are required to make fixed monthly payments for the loan’s duration.

Collateralized vs. Non-Collateralized Installment Loans

Installment loans can be either collateralized or non-collateralized. Collateralized loans require borrowers to pledge an asset against the amount of loan borrowed. For auto loans, the motor vehicle being purchased using the loan amount is used as the collateral for the loan until the loan is fully paid.

Similarly, for a mortgage loan, the collateral for the loan is the house being purchased using the borrowed funds. The borrower does not fully own the house until the loan is fully paid. Before the installment loan is disbursed, the collateral must be valued at the fair market value to determine if its value is adequate for the amount of loan borrowed.

Non-collateralized installment loans do not require the borrower to provide a collateral for the loan. Instead, the lender extends credit based on the borrower’s creditworthiness and ability to repay the loan based on past credit history and current cash flows.

During the loan review process, the lender may request the borrower’s credit report from the credit bureaus to ascertain the borrower’s creditworthiness. Due to the high risk of lending such loans, lenders charge a higher interest rate for non-collateralized loans than collateralized loans.

Related Readings

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• Amortizing Loan
• BNPL (Buy Now, Pay Later)
• Effective Annual Interest Rate
• Quality of Collateral
• Secured Loan vs Unsecured Loans
• See all commercial lending resources