What it is:
How it works (Example):
Installment debt, also called an installment loan, is granted to the borrower with a preset number of monthly payments of equal amount. These amounts are amortized to include a certain amount of principal and interest calculated over a set number of months. Once the borrower successfully submits all of these payments in their entirety, the loan is paid off.
To illustrate, suppose someone takes out a loan for $1000 at an interest rate of 10% (or 0.10) annually to be repaid in 12 monthly installments.
$1000 + ($1000*0.10) =
$1000 (principal) + $100 (interest) =
$1100 to be repaid in 12 installments
$1100/12 months = $91.66 per month
The borrower must pay 12 monthly installments of $91.66 each. This $91.66 comprises a portion of principal and a portion of interest. When the borrower pays the twelfth and final installment, he will have completely repaid the loan.
Why it Matters:
When someone takes out a loan, his interest obligations accrue periodically at a specified rate. If left unpaid, the interest simply continues to accrue, requiring the borrower to repay more and more. An installment loan provides the borrower with a structured number of manageable, albeit mandatory, periodic installments. The structure of the loan also provides assurance to the lender that his or her loan will be repaid.