As with any financing mechanism, though, it’s important to consider the pros and cons of installment loans. To that end, we’ll start with an installment loan definition, then outline the pros and cons of this financing option as they pertain to small business owners.
What is an Installment Loan?An installment loan is a form of debt that you (as the borrower) pay off in fixed payments over a set period of time. Part of each loan payment goes towards repaying the loan principal and the other part goes towards interest. This business loan type has a fixed or variable interest rate, repayment period, and fees. The fees, rate, and period all determine your monthly payment and total interest expense. Most of the loans you probably know about are various types of installment loans. Examples of installment loan options include:
- Student, auto, and personal loans
- Business and construction loans
- SBA 7(a) loans
The Pros of an Installment Loan
1. Predictable repayment termsWhen you take out this loan type, you know when your payments are due and when they end. This predictability helps remove cash flow uncertainties you might experience with payment terms that aren’t as rigidly set. For example, with a merchant cash advance—which isn’t an installment loan—remittance is based on your credit or debit sales. Therefore, if your sales slow down, it’ll take longer to fulfill your financial obligations. Of course, if your sales increase, you’ll remit the advance back faster. In either case, you can’t predict what your sales might do so repayment isn’t as predictable. When you pursue this type of financing, you won't be able to fully predict when your cash advance will be remitted. If this level of unpredictability concerns you, pursuing a loan with set terms may be a better funding option for you.
2. Large loan amountsCompared to other types of debt, such as a revolving credit line or credit card, installment loans give you access to more funds. Limits on credit lines usually don’t go above $250,000 whereas the average SBA 7 (a) loan in 2020 was $567,599. Of course, that doesn’t mean that you can’t get a smaller installment loan; alternative lenders that provide microloans regularly lend installment loans of just a few thousand dollars. In addition, you shouldn't take out a large loan amount if you don't need it, as this could put a strain on your future cash flow if you can't afford to pay it off.
3. Wide variety of optionsIf you need to borrow money for your business, it’s well worth your time to explore all of your options. Installment loans come in many different varieties which ensures you have a great chance of finding a good fit. There is even a range of installment loans specifically designed for certain industries. This includes industry specific loans such as:
- Construction loans for contractors
- Medical practice loans
- Restaurant business loans
- Retail financing
- Startup business loans
The Cons of an Installment Loan
1. Potential for costly loan feesInstallment loans often come with a laundry list of fees, including fees for:
- Late payment fees
2. Inflexible payment termsThe same repayment predictability that some entrepreneurs enjoy about installment loans can be overly rigid for others. Other financing options, such as invoice factoring, merchant cash advances, or bridge loans offer more flexible payment options. For example, merchant cash advances scale up your remittance amount based on your current sales. Similarly, bridge loans often come with no payment (or interest-only payments) until they become due in one balloon payment at an agreed-upon date. If this kind of flexibility is important for you, installment loans may not be ideal.
3. Use of funds restrictionsIt’s not always the case, but many installment loans have restrictions on what you can use your funds for. For example, you can only use SBA 7(a) loan proceeds for the following expenses:
- Working capital
- Real estate acquisition
- New construction
- Business startup costs