Let me paint you a picture. You apply for a loan and feel downright giddy after you get approved. But that joy only lasts so long before the newness wears off and you realize that you’ll be shuffling out monthly payments for what feels like an eternity.
The period you’re dreading is known as the loan term, and it can make you feel as if you’re rolling a rock up an endless hill — depending on how long it is. Simply put, the loan term is the amount of time you have to repay a loan.
A loan term is how long you have to repay the money you owe, and should be clear well before you sign any paperwork.
But instead of letting it get you down, the best thing to do is face it head-on, sort out how you feel about it, and then make your payments on time like a responsible borrower. You can even make extra payments to shorten the term if you want.
I’m going to help you on this financial journey by explaining how the loan term length impacts your monthly payments and how much interest the lender is going to wring out of you.
How Loan Terms Work
Before jumping in and signing a loan agreement, it’s essential to understand what the term of a loan really means. This little detail will affect how long you’ll be tied up paying the loan and how much it’s going to cost you in the long haul.
What a Loan Term Represents
The loan term is the period determined by both you and the lender to pay back the full amount of money you borrowed. Most of the time, you are going to be working with what is called an installment loan, where you send off the same payment every month until the debt is repaid.
Alternatively, your loan may require only a single payment on a certain date. Payday loans are a well-known example. That loan may seem friendly upfront — no monthly payments — but don’t get too comfortable because there’s a lump sum payment waiting for you at the end of the loan term and payday loans are anything but borrower-friendly.
Regardless of its structure, you must understand what kind of loan you’re wrangling with before signing your name on that dotted line.
How Lenders Determine Terms
Lenders don’t just pull loan terms out of their hats. They take into consideration all sorts of things before deciding just how long you’ll be on the hook. First, it depends on what type of loan you’re taking out. Bigger loans, such as mortgages, have longer terms because not as many people can afford to buy a house with cash or in just in a few years.
Lenders also consider the amount you’re asking for. The bigger the loan, usually the longer it takes you to pay it back. It’s easier on your wallet to stretch the loan out, even though that means more interest out of your pocket.
Finally, it all depends upon the specific policies of the lender. Some are as flexible as a scarecrow in the wind, letting you choose a term (within certain limits), while others are stiff as rigor mortis and impose fixed terms. So, you better know what kind of lender you are dealing with before you sign that loan agreement.
Common Loan Term Lengths
When buying a house, you’re generally looking at a very long trail ahead. Mortgage loans stretch typically from 15 to 30 years. It’s like marrying your debt, and you’ll be repaying that thing longer than some folks stay together. But of course, the longer term equates to smaller monthly payments, though you do end up paying more interest overall.
A car loan is shorter, usually three to seven years. Think of it as a midsized commitment. The shorter the period for your loan, the larger the payments are. However, you pay less interest when the term is short, and that ride belongs to you sooner.
Personal loan terms are all over the map, although they’re commonly one to five years in duration. Whether you’re fixing up the house, paying off medical bills, or maybe even taking a vacation, you’ll need to pay close attention to the loan term because the shorter it is, the quicker you’ll be free from that debt.
The Financial Impact of Your Loan Term
If you intend to borrow, it would be wise to look at how different loan terms can affect your monthly payments, the interest you will owe, and how these fit into your budget. Loan terms aren’t just numbers; they directly impact your lifestyle.
Monthly Payments
The length of your loan term directly controls how much you’ll be shelling out each month. A shorter term requires higher payments, but it means that you will be through sooner — taking the short way around the mountain, so to speak. A longer term will stretch things out for a lower monthly hit, kind of like following the scenic route.
While a longer term may be easier to manage each month, you’ll end up paying more once the trip’s over.
For example, imagine that you borrow $20,000. With a five-year term and a 6% interest rate, your monthly payments will be $386.66. Your ordeal will end in five years, but that’s still a pretty large amount of cash leaving your wallet every month.
Now, stretch that loan out to 10 years with that same 6% rate. Your monthly payment drops to $222.04. That’s a lot easier to swallow month to month. But, of course, just remember you’ll be making payments a whole lot longer.
Interest Over the Life of the Loan
While extending a loan term may make those monthly installments lighter on your wallet, here’s the catch: You’re going to end up paying a whole lot more interest over time. The longer you take to pay off that debt, the more money the lender is going to extract from you.
Let’s revisit our example of $20,000. With a five-year term and 6%, you’ll wind up paying $3,199.76 in interest by the time all is said and done. That is not too terrible, but you will be feeling the squeeze each month.
Stretch that loan out to 10 years, and your monthly payments are easier. However, you’ll pay $6,644.88 in interest over 10 years. That’s over twice as much interest, all because you took twice the amount of time to pay it off.
Managing Your Term Length
When choosing the right term, consider your financial goals and how much strain your wallet can handle. If you’re into paying off that loan rapidly and saving on interest, then shorter terms are the way to go. Sure, those monthly payments will feel like trying to lift a heavy barbell, but you’ll be done quicker and pay less overall.
If, on the contrary, you want to keep those monthly payments as low and easy to swallow as possible, the longer term will be more to your liking. Remember, while it may ease the burden now, it’s going to cost you more down the road in interest.
Whether you go with an installment loan or a one-payment deal depends on your situation.
An installment loan is good when you might want to stretch out the payment predictability — the same payment every month, like clockwork, until it’s all paid off. This is usually the best choice for bigger purchases, such as cars or homes, where it makes sense to extend the payments over time.
But if you’ve only got a short-term need or you know you’ll be coming into a chunk of money soon, a one-payment loan may fit better. You make no payments until the due date. Make sure you’re ready for that big payment when it comes due, or you will be in a world of hurt — and possibly a cycle of debt.
Common Loan Terms Among Different Loan Types
It’s vital to understand how loan terms can change depending on the type of loan you are looking at since what works for a house isn’t what’s best for a car or a personal expense. Knowing the differences will enable you to pick a loan term that fits like a glove.
Mortgages
When you’re considering terms, it isn’t just about picking 15 or 30 years on a fixed-rate mortgage and calling it a day.
Different types of mortgages have their own special ways of stretching things out, and you know best what you’re signing up for before you’re knee-deep in sky-high payments.
For an adjustable-rate mortgage (ARM), the term is usually five or seven years, but then, a balloon payment comes into play.
That means after the term ticks away, you may have to cough up one huge payment all at once. If you can’t pay up, you can refinance your home — or sell it.
Auto Loans
With car loans, you’re usually looking at three- to seven-year terms. The shorter the term, the larger the monthly payment is, but the faster you will have complete ownership of that vehicle.
A longer term may make the payments smaller, but you will pay more in interest, and your car may depreciate faster than you can pay it off. The term may matter if you’re deciding between buying or leasing.
The typical lease for a car is three years, at which point you turn the car back in, purchase it, or start all over again with another lease of a newer model. Now a three-year lease term may sound like it would require larger monthly payments than for, say, a seven-year loan.
However, lease payments cover only a portion of the car’s selling price — equal to the amount the vehicle will depreciate in three years. So, the monthly payments for leases and loans may be similar, and you should decide which to get by looking at other factors.
For one thing, a loan gives you that satisfying feeling of ownership once you have paid the car off. Still, if you aren’t careful with the term, you may find yourself paying years for a car that is depreciating faster than you can say “rust bucket.”
Just remember, miss your car payments, and the repo agent could come calling. If you think you may struggle with the higher payments of a shorter-term auto loan, then you’d better stretch that loan term out. You want to ensure that no one from the bank shows up in your driveway to haul your car away.
Personal Loans
Personal loans are available in all shapes and sizes, and their terms generally run anywhere from one to five years or longer. The shorter the term, the higher the payments will be — but you’ll also save on interest and be debt-free sooner.
If you have some room in your budget, it’s often better to bite the bullet and opt for a shorter term. But if you need a lower monthly payment, you can stretch it out. Just remember, the longer the term, the more you’ll pay in interest.
When choosing a term, consider what you are taking out the loan for. For example, if it’s for home improvement or to pay off another debt, the term can be longer just to allow some wiggle room.
But with smaller expenses, try to wrap it up in the quickest time possible and save yourself some coin.
Choosing the Right Loan Term for You
Picking the right loan term requires practical advice so you don’t end up biting off more than you can chew.
Evaluating Your Financial Situation
Before setting your loan term, you need to take a closer look at your money situation. If your income is good and your bills are pretty cooperative, you may be in a good enough position to take on a shorter loan term. However, if you make it through each month, be much more cautious not to overextend by choosing a longer term.
Take stock of what you can comfortably afford each month and plan accordingly so you aren’t stretching yourself too thin.
Think of your savings, your expenses, and those little surprises that always seem to come up, such as that old car finally giving up the ghost or an unexpected hospital visit.
It was all about making sure you could meet your loan payments without throwing your whole budget out of whack. Sure, a longer loan term may sound like an easier ride, but it’s not always the best deal if it’s going to keep you in debt for years on end.
Long-Term vs. Short-Term Loans
A long-term loan requires less sizable monthly payments. It’s a good choice if you feel like making your life a little easier. It’s a slow and steady way to keep more money in your pocket each month.
The thing is, though, those monthly interest payments add up like rain filling a bucket: slow at first, but before you know it, you’re drenched.
Long-Term Loan | Short-Term Loan |
---|---|
Lower monthly payments | Higher monthly payments |
More interest paid over the life of the loan | Less interest paid over the life of the loan |
Personal loans tend to have lower interest rates, whereas auto loans and mortgages have higher rates | Personal loans tend to have higher interest rates, whereas auto loans and mortgages have lower rates |
With a short-term loan, wherein you pay more each month, you will be out of debt quicker. They’re harder on the immediate budget, but you get there quicker and typically with less interest weighing you down, depending on the loan type. If you’re able to stomach the steeper climb, in the end, you’ll save money by choosing a shorter-term loan.
Refinancing to Change Your Loan Term
When your current loan term has you feeling squeezed or lower interest rates become available, refinancing might be the fix. Refinancing allows you to make changes to your loan to better fit your situation.
If you are having a tough time making high monthly payments, then you can stretch the term out and lower them. On the other hand, if you’ve got more cash flow now than when you first took out the loan, you can shorten the term and get rid of that debt sooner.
But don’t jump into refinancing without looking at the costs. Sometimes, the refinancing fees and new interest rates can sneak up on you. Weigh the benefits against the costs to make sure it’s going to save you money over the long haul.
Explore Your Loan Terms Before Accepting Financing
Before you go signing on the dotted line, make sure you’ve got a handle on all the loan terms. If you jump in too quickly without knowing what’s what, you might find yourself strapped to payments longer than a Peter Jackson film festival.
So, take a good, long look and make sure the terms fit you like a pair of well-worn boots, or you’ll regret it faster than an embarrassing tweet going viral.