Installment loans seem to be a simple idea—borrow money and pay it back over time, plus fees—but they hide a lot of complexity. We break down how installment loans work for borrowers with bad credit.
Installment loans: A simple phrase with a lot of complexity
You may not know what “installment loan” means, but chances are you know what it is. Installment loans are what most people think of when they think of a “loan.” A person borrows a lump sum of money to cover an expense now. Then they pay that lump sum back over time.
Simple concept, right? Sure—but that simple concept hides within it a complicated web of details. Those details become even more important to understand when you have bad credit.
What does the “installment” part mean? What happens when you apply for online installment loans? Why aren’t you getting approved? If you do get approved, are you getting a fair deal? At Klya, it’s our mission to make the process of taking out online loans open, transparent, and fair. Let’s break it down.
What are installment loans used for?
People take out installment loans all the time. Sometimes those loans are for specific goals, such as starting a business, purchasing a car, or buying a house. However, sometimes folks just need to take out a loan for an expense that they don’t have the cash on hand for. According to Forbes, common uses of personal loan money include doing home repairs, paying for a major purchase, and consolidating debt (meaning you have a lot of different loans and you take out one to pay them all off—that way you just have to manage the one).
Loans for these general life expenses are called personal loans. Since personal loans are paid back in installments, you’ll often see the term “personal loan” used interchangeably with “installment loan.”
The three parts of an installment loan
First, we need to unpack the terminology of loans. We’re going to give you a simple overview. There’s a lot more to learn, but that’s part of what we’re here for: to help you through the learning process.
To start out, here are the three main parts of an installment loan:
- Principal: The amount you borrowed. If you took out a $10,000 loan to fix a leaking roof, the $10,000 is the principal.
- Installments: The number of payments. Most loans are paid back monthly, so in those cases, every installment is a month. Let’s say your lender says you can pay that $10,000 principal back over 24 monthly installments. That means they’re asking you to pay once a month for 2 years (2 years x 12 months = 24 installments). They’ll divide your $10,000 in principal into monthly payments, plus . . .
- Interest: A percentage the lender is charging you on top of the principal. This is how the lender makes money. Rates vary from lender to lender and person to person. Interest rates up to 36% are common for folks with bad credit. While that sounds high, it is still much better than the triple-digit interest rates borrowers can face when taking out payday loans.
How those numbers work
Let’s use all those concepts together. You apply for an installment loan of $10,000 in principal and get approved. You have 24 installments to repay the loan, and it has a 36% interest rate. (Bear with us, there are a lot of numbers coming!)
- First, you need to understand the total interest you’ll pay. To do that, multiply the interest by the principal.
So $10,000 x 36% = $3,600 is what you’ll pay in interest.
- Next, add that interest payment to your principal. That tells you the full amount you’ll have to pay the lender.
$10,000 + $3,600 = $13,600 is the amount you’ll pay back.
- Finally, divide the total you’ll pay back by the number of your installments. That’s your monthly payment amount.
$13,600 / 24 = $566.67 is your monthly payment amount
Remember, this is a simple example. The way the lender applies interest could change, and there could be other fees, such as origination fees that lenders charge you just to take out the loan. Make sure to understand your total payments when talking to your lender. Some lenders will speak in percentages—Don’t let them! That can end up hiding how much you’ll really pay. Make sure they talk in amounts.
Now you know the parts of an installment loan and how it works. What happens when people with bad credit try to apply for one?
Quick recap: Bad credit
Briefly: Credit bureaus receive data on your financial history from your banks, credit cards, and other lenders. The bureaus compile that data—your credit history—into a credit score. Credit scores say how well you’ve done at managing debt. If you have a lot of debt or you have a history of late payments, to name a just few factors, that leads to a worse credit score. (We covered in-depth what makes up your credit score here.)
Credit scores range between 300 to 850. The higher the score, the better it is. Lenders consider scores of 669 or below “bad credit.”
What happens when you apply for an installment loan
When you apply for a loan, you may hear the term “underwriting.” That means lenders are reviewing your financial profile. They do this to understand two things:
- How much they want to lend you (principal)
- How much they want to charge you (interest)
Depending on the type of loan you’re taking out, the information lenders consider about you can vary, according to personal-finance company NerdWallet. They may look at how much is in your bank account, how much you make, whether you have other investments, and of course, what your credit score is. Depending on the nature of the loan—Is it a home loan, for example?—there may be other specific documents or details that the lender will ask for.
Lenders use this information to build a picture of the borrower’s financial story, past and present. Then they compare that with the loan amount requested. Finally, lenders make an assessment.
The more likely they think it is the person will pay, the more likely they are to see the loan as low risk. They’ll charge the borrower lower interest, or offer more generous payment terms—lower monthly amounts over a longer time, for instance. But the less likely they think it is that the person will pay, the greater the chances are that they’ll see the loan as high risk . In that case, they will charge more in interest and may try to apply severer payment terms: fewer installments with higher amounts.
That’s all well and good. But when online direct lenders evaluate personal loans for bad credit, they usually only look at the credit score. That means those borrowers often get denied. Or, if they are approved, they face high interest rates—a bind for people who have tight finances already.
How most lenders think about bad credit
Why do direct lenders who underwrite loans for people with bad credit look only at credit scores? We think it’s because the financial system is stacked against folks with bad credit. How? It treats them as a risk to be avoided. In 2018, a LendEDU survey found that the denial rate for personal loans was about 76%, and that of the 24% who were approved, the average applicant had a credit score of 741.
So most direct lenders want to lend to good credit scores. From a risk-avoidance perspective, this makes sense. They understand a bad credit score to mean that you’ve had trouble managing debt in the past. Or, they could see it as meaning you don’t have enough history to tell them whether you can manage debt or not.
No matter how they interpret it, the result is the same: The lender won’t approve the loan because they don’t want to take a loss. And, you don’t get the fast funds you need.
Klya believes that’s the wrong approach. We look at your credit score, of course, but that only tells us your past activity. We’re more interested in where you are and where you’re going. That’s why we consider factors such as your income. We believe that’s a fairer—and more accurate—way to understand borrowers. In fact, our unique model almost guarantees approval as long as you’re being honest with the information you submit in your application.
Find out what it’s like to work with a lender that puts you first.
Ready to apply?
Now you know the main pieces of installment loans and how they come together, what those loans can be used for, and why borrowers with bad credit have trouble getting approved with most online direct lenders. We hope in making this clear, we’ve shown you we are a lending partner who is there to support you through the process of taking out a personal loan.