How to Choose the Right Loan Term

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Category: Loans
Posted on: 08/20/2020
How to Choose the Right Loan Term

Shopping for a loan that fits into your finances is easier said than done. It takes time, research, and understanding of the different factors that make up a loan and how they will affect your finances. One of these elements to consider is the loan's term. The loan's length directly impacts how much you'll end up paying each month against the loan and the amount of overall interest you'll pay over the course of its lifetime.

For your business, real estate, or home mortgage, the loan's term length can make a big difference in what you end up paying—not just monthly, but overall when it's all said and done. Here are a few guidelines to help you choose the right term loan when making big investments:

Know What the Loan Term Will Affect

The length of the loan is a big deal. When you know what the loan's term will change, you can envision what you'll pay each month, your budget and finances, and how to plan for the loan more effectively. The length of the loan impacts the other features of the loan itself like:

  • Your monthly payment, including what will go towards the loan's principal and interest
  • The amount of interest you'll pay over the course of the loan's lifetime
  • Your interest rate for the loan

There are online tools and resources that you can use to input the interest rate, the loan term, and the loan's total amount to help calculate your monthly payments, displaying how the monthly payments change when the loan's term length changes. With these tools, you can get a better idea of how the loan's length affects your payments, the interest you'll pay, and the interest rate (if the lender offers different rates for longer or shorter terms).

Your lender can also provide you with an amortization schedule to show you how your payments will affect the loan's principal and interest each month beneath a variety of loan terms and rates. It can help to view all of the loan products the lender offers in an organized amortization table to see how the different loan terms pay down the loan amount and what you can save on interest over its lifetime.

Long Term Versus Short Term

Your options with loans broadly fall into two different categories: long-term and short-term loans. Short-term loans are designed for smaller loan amounts like personal loans, and long-term loans are meant for bigger investments like a business, a home mortgage, or a new vehicle. 

Generally speaking, you'll save more money with a shorter-term loan. There's less time for the interest to accumulate and build, and you're paying back the loan more quickly so the lender will often issue a better, lower interest rate. Lenders see the borrower as less of a risk with a short-term loan, and therefore the interest rate is lower because they don't feel as great of a need to protect themselves against a potential default. 

The downside of a short-term loan is that your monthly payments are higher. You don't have as much time to pay back the loan amount, so the repayments are higher because they aren't as spread out. Although it would be nice always to have the opportunity to have a short-term loan and save money in interest, in the end, not everyone has the cash to do so.

For long-term loans, the interest rates are higher, but the monthly payments are dramatically lower than that of a short-term loan. Lenders see long-term loans as a greater risk. They're lending out to borrowers for typically higher amounts, the price of a house, a business, or a new car, and over a longer period of time. 

For lenders, that's more exposure and a greater chance that a borrower could possibly default. The lender issues a higher interest rate on a long-term loan to protect themselves should the borrower miss payments or default completely. In other long-term loan instances, collateral is used to secure the loan, like a house, real estate, or the physical inventory of a business. That way, in the case of a default, the lender can easily liquidate the assets to regain losses.

As the borrower, a long-term loan may have a higher interest rate, and the loan will require that you ultimately pay more in interest over time, but the monthly payments are manageable. For something as substantial as a home mortgage, a short-term loan wouldn't quite fit—you'd have insanely high monthly payments on a house worth a couple of thousand dollars. A long-term mortgage loan is standard—about 15 or 30 years in length—spreading out the payments to lower them into manageable monthly amounts.

An example would be a $200,000 mortgage with the option of either a 30-year or a 10-year term. For a 30-year loan with a fixed interest rate at 3.37%, your monthly principal and interest payment would be $884. If you opted to have a 10-year loan with a fixed-rate at 2.75%, your monthly principal and interest payment would be much higher at $1,908, but you'd pay less overall. You would be saving $89,280 in interest with the 10-year loan as opposed to the 30-year loan.

Interest Rates and Loan Terms

Loan terms and interest rates go hand-in-hand. Lenders often issue different interest rates for different term lengths, and generally, the longer the term, the higher the interest rate you'll see. 

Rates always vary among lenders, and this is especially true for short-term loans. If you think a short-term loan is a good fit for the amount and purpose you're using it for, then be sure to shop around to compare lenders and their varying interest rates. 

One factor that stays consistent is the length of a short-term loan. The interest rates may be all over the board from lender to lender, but if you've at least settled on a short-term loan length, then all you have to do is narrow down if you want to pay back the loan in a few months of up to a year, the standard terms for short-term loans.

Much of finding which loan term is right for you is reliant on the interest rate. Even if you should find that the loan term is suitable, the interest rates could be through the roof. Doing your research on interest rates is just as essential as deciding the term length because both will determine how much you ultimately pay in interest.

A Look at Your Finances

Let's go back to the earlier example of the 10-year versus the 30-year mortgage. While it would be ideal to save $89,280 in interest, a monthly payment of $1,908 simply doesn't make sense for most Americans. A monthly payment of $884 with a 30-year loan term is much more reasonable for many homeowners and fits well into budgets.

How do you choose the right loan term? It comes down to the monthly payment and how you feel about paying the loan's interest. If you have the funds and financial standing, a short-term loan can save you money. Realistically, however, a long-term loan is better suited to the average borrower's need for larger loan amounts.

Finance Guru

Finance Guru