Credible takeaways
- Borrowers may choose a longer loan term if they’re borrowing a large amount of money or if they prefer lower monthly payments.
- You might opt for a short loan term if your loan amount is low or you’re focused on paying less in interest.
- Shorter loan terms come with higher payments, so you’ll need to consider this when deciding which is best for you.
When you’re taking out an installment loan, the lender may give you several options for a repayment term. Choosing the right loan term impacts your monthly payment and total cost of borrowing, as well as the amount of time you’ll be making payments. Here’s a closer look at how loan terms influence your overall cost of credit and what to consider when choosing your repayment period.
What are loan terms?
A loan term reflects the amount of time you’ll spend repaying debt. Loan repayment periods vary depending on the size of the loan and its purpose. For instance, borrowers usually have up to 30 years to pay off a mortgage because these loans typically involve a large amount. Auto loans, student loans, and personal loans are usually smaller and paid over a shorter time frame, such as three to 10 years.
How do loan terms affect the cost of credit?
The loan term you choose affects more than just the amount of time you’re in debt. It also impacts your interest costs and monthly payments.
Relationship between loan length and monthly payments
Longer loan terms result in lower monthly payments because they’re spread over a longer period of time. Meanwhile, shorter-term loans condense your balance into fewer installments, increasing your monthly payments.
Impact on total interest paid
You’ll generally pay more interest with a longer loan term for two reasons:
- Longer payoff timeline: Lenders charge interest with each monthly payment, so a longer loan term naturally results in more interest payments.
- High interest rate: Higher rates on longer-term loans also increase your interest costs. You’ll pay less in interest when taking out a loan with a shorter term.
For example:
If you took out a $20,000 loan with a 10% interest rate and a 10-year term, you’d end up paying about $11,716 in interest. A five-year term, on the other hand, would result in roughly $5,496 in total interest.
Effect on interest rates
There’s a relationship between interest rates and loan terms. Generally, borrowers pay a higher interest rate on a loan with a longer term and vice versa. That’s because a longer term leaves more risk for the borrower to default. The same borrower would likely receive a lower rate if they opt for a shorter term.
Short-term vs. long-term loans: Pros and cons
Both longer and shorter repayment periods come with benefits and drawbacks. Consider these factors before you make your decision:
Pros and cons of short-term loans
Pros
- Pay less in interest: Shorter-term loans often have lower interest rates and fewer monthly installments, which result in lower interest costs.
- Get out of debt faster: After paying off your loan in a shorter period of time, you’ll have funds available for other financial goals, like retirement or emergency savings.
Cons
- Smaller loan amounts: Short-term loans come with higher monthly payments, which increase your debt-to-income ratio (DTI). You may qualify for a lower loan amount as a result.
- Less budget flexibility: Higher monthly payments leave less room in your budget for other expenses.
Pros and cons of long-term loans
Pros
- More manageable payments: Long-term loans come with lower installment payments, allowing you to cover other living expenses.
- Higher loan amounts: Because long-term loans shrink your monthly payments, you may be able to borrow more.
- Allows for flexibility: When you have extra funds, you can lower your interest costs and shorten your payoff timeline by paying more toward the principal. (This only applies to loans that don’t charge a prepayment penalty.)
Cons
- Higher interest costs: Your interest rate typically increases when you lengthen your loan term, and you’ll have more interest payments to cover.
- Longer debt-payoff timeline: Choosing a longer-term loan means being in debt for more time.
Factors to consider when choosing a loan term
When choosing a loan term, think about how much you can afford to pay each month and whether your income may change over time.
Financial goals and budget
Check your budget and consider what you can realistically afford to pay each month. Then, “consider long-term goals like retirement and future income,” says Bruce McClary, senior vice president of communications and membership at the National Foundation for Credit Counseling.
For instance, McClary says, choose a shorter loan term if you want to shrink your interest costs. But if you can’t afford the higher payments, you could choose a longer term and pay more toward the principal when you’re able to.
Income stability and future plans
If your income fluctuates or you’re unsure about the future of your job, you might choose a longer loan term with lower monthly payments. This adds breathing room to your budget and provides flexibility during months when your income is low. On the other hand, you might be comfortable with a short loan term (and higher payments) if your cash flow is more stable.
Potential changes in interest rates
When interest rates are high, borrowers often look for ways to save money. One option is choosing a shorter loan term to qualify for a lower rate. If you do this, just make sure you’re comfortable with the higher payments.
How to calculate the total cost of a loan
To help you choose between loan terms, estimate the total interest paid over the loan duration. Here’s how to calculate the interest, payoff schedule, and other costs:
Using loan calculators to estimate payments and interest
A loan calculator can help you estimate your monthly payment and total interest costs over the life of the loan. Just plug in your potential loan amount and interest rate, and see how different loan terms affect what you pay.
Understanding amortization schedules
An amortization schedule dictates how much of your payment goes toward principal and interest each month. When you first take out an installment loan, more of your monthly payment goes toward interest rather than principal. Paying more money toward your principal can help reduce your interest costs.
Tip:
If you plan to choose a long-term loan and put more money toward the principal, consider paying extra in the initial months to increase the impact on your bottom line.
Considering additional fees and charges
When calculating your total monthly payment, don’t forget to factor in any extra charges the lender may impose, such as application, origination, processing, and underwriting fees.
FAQ
Can I change my loan term after I've started repaying the loan?
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How does the loan term affect my credit score?
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Are there penalties for paying off a loan early?
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How do adjustable-rate loans impact the cost over different terms?
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