How Do Loan Terms Affect the Cost of Credit?

What Are Loan Terms?

The word "term" can mean two things in the context of a loan. It can refer to the repayment period, which is how long you have to pay back what you borrowed. It can also refer collectively to all the conditions you agree to when you take out a loan.

Here are some of the key terms you'll find in a loan agreement:

• Term length: The amount of time you have to repay the loan, typically expressed in months or years. Personal loans, for example, commonly come with terms ranging from one to seven years.
• Annual percentage rate (APR): The yearly cost of borrowing, including the interest rate and certain fees. APR gives you a more complete picture of a loan's cost than the interest rate alone.
• Fees: Additional charges that may be part of the loan agreement. These can include origination fees, late payment fees and prepayment penalties.
• Monthly payment: The amount you'll pay each month, which typically includes both principal and interest.
• Collateral: An asset you pledge to secure a loan. Secured loans require collateral, while unsecured loans do not.

When you're comparing loan offers, it's important to look beyond the monthly payment and consider how all of these terms work together. A loan with a lower monthly payment might seem like the better deal, but the total cost could be much higher if the term is longer or the APR is higher.

How Do Loan Terms Affect the Cost of Credit?

Two primary factors determine how much a loan will cost you over its lifetime: the interest rate and the repayment term.

Interest Rate

Your interest rate is the percentage a lender charges you to borrow money. A higher rate means you'll pay more for the same loan amount. Rates can be fixed, meaning they stay the same throughout the life of the loan, or variable, meaning they can fluctuate over time.

Repayment Term

Your repayment term determines how long interest accrues on your balance. Even if two loans have the same interest rate, the one with a longer term will cost more in total interest because you're carrying the debt for a longer period.

Each month that a balance remains outstanding, interest is calculated on the remaining principal. So, the longer that process continues, the more you'll pay.

Pros and Cons of Short-Term Loans

The decision between a short-term loan and a long-term loan often comes down to the monthly payment. But it's still important to consider all the potential advantages and disadvantages of each option before making a decision. Here's a look at some benefits and drawbacks of a short-term loan.

Pros and Cons of Long-Term Loans

As with short-term loans, it's important to also consider the benefits and drawbacks of a long-term loan before proceeding.

How to Calculate the Total Cost of a Loan

To find the total cost of a loan, multiply your monthly payment by the number of months in your repayment term. Then subtract the original loan amount from that figure to see how much you'll pay in interest alone.

Here's the basic formula:

• Total amount paid = monthly payment x number of months
• Total interest paid = total amount paid - loan amount

For example, if your monthly payment is $304 and your term is 60 months, you'd pay $18,240 in total. On a $15,000 loan, that means $3,240 in interest.

Many lenders provide this information upfront when you apply or prequalify for a loan. You can also use an online loan calculator to estimate costs before you commit.

Loan Length and Cost of Borrowing Example

To illustrate how term length affects costs, let's compare two $15,000 personal loans with the same 10% APR but different repayment terms:

In this example, the five-year loan has a monthly payment that's $165 lower. However, you'd pay $1,698 more in total interest over the life of the loan. That's the tradeoff: Lower monthly payments come at the cost of paying more overall.

Personal loan calculator

How to Choose the Best Loan Length

Selecting the right loan term depends on your financial situation and priorities. Here are some factors to consider:

• Monthly budget: Review your income and expenses to determine how much you can comfortably afford each month. A budget can help you figure this out.
• Total cost: If minimizing interest is your priority, a shorter term will save you money over the life of the loan.
• Financial goals: Consider how the loan fits into your broader plans. If you're also saving for a home or building an emergency fund, lower monthly payments might make more sense even if they cost more in interest.
• Interest rate: Compare the rates offered for different term lengths. If the rate difference is significant, it could tip the scales toward one option.
• Prepayment options: Some loans allow you to pay off your balance early without a penalty. This can give you the flexibility of a longer term with the option to save on interest by paying ahead of schedule.
• Your credit profile: Your credit scores can influence the rates and terms you're offered. Stronger credit can help you qualify for better terms, which gives you more options to work with.

Frequently Asked Questions

Find the Right Balance

Choosing a loan term is about finding the sweet spot between affordable monthly payments and a reasonable total cost. Before you commit, take time to compare offers, run the numbers and consider how the loan fits into your overall financial plan. You can check your credit report and FICO^® Score^Θ for free through Experian to understand where you stand before applying.