Long vs. Short Term Loans: Do You Know the Difference?

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Category: Loans
Posted on: 07/06/2021
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There’s more to a long-term and short-term loan than its term length. Knowing the difference will determine your repayment amounts and the amount of interest you’ll pay at the loan’s conclusion. Both types of loans are lending solutions that can benefit unique financial situations.

Both loans fall under the umbrella category of term loans. Essentially, the lender provides a lump sum of cash right into your bank account. As the borrower, it’s your responsibility to repay that amount, plus the predetermined amount of interest, over whatever term length the loan has. That’s where the loan options branch off into short-term loans and long-term loans.

How Does the Term Length Affect Your Loan?

In a short-term loan, you’ll have higher monthly repayments because there are fewer repayments overall. Typically, the length of a short-term loan is anywhere from 3 to 18 months, but most lenders commonly categorize their short-term loans by issuing them for less than a year. The fact is that interest has less of an opportunity to accumulate during a shorter period of repayment.

Long-term loans are a little more flexible with their true definition. Usually, a long-term loan is defined as any loan with a period of 24 or more months to repay. Long-term loans and medium-term loans can be muddled together. Still, mainly, lenders define their long-term loan products with repayment periods extended to 5 to 10 years, or even longer if the loan is for something like commercial real estate.

The term lengths will dictate what you pay against the loan each month. For example, you could have a loan for $10,000 with a 6% APR. Your lender has options for the loan’s length: one year, three years, or five years. A one-year loan would be considered short-term.

You’d have a monthly repayment of $860.66, and the total amount of interest you’d pay back on the loan would be $327.97. A three-year loan would be edging towards a medium-length loan, and you’d be issuing a monthly repayment of $304.22 with the loan’s lifetime interest of $951.90. Finally, a five-year loan would be considered a long-term loan, and you’d make payments of $193.33 each month with a total interest of $1,599.68.

As you can see, the short-term loan means you’re paying less in interest, costing you about five times less than the long-term loan of 5 years. There’s a catch—the monthly payments you’d be making with the short-term loan are over four times higher than that of the 5-year long-term loan.

But while this example demonstrates how your overall interest and repayments will differ between term lengths, the next question that often arises is: do the term lengths of a loan affect the interest rate?

Term Lengths and Interest Rates

The answer is: it depends. Some lenders do have higher rates the longer the loan term. For example, a loan term of 1 year could have an APR of 6.74%, but a loan for five years issued by the same lender could have an increased APR of 10.74%. In essence, you’d be paying more in this case to have a manageable, lower monthly payment with a longer-term. It’s the cost of convenience—and greater risk—and for a lender, they want to be getting something out of extending the borrower a longer payback period.

In the case of a lender offering a loan with a short-term repayment period and a long-term repayment period, there’s the question of the origination fee. In getting a longer loan term, you could also be facing a higher percentage of your loan amount as the origination fee. This is something to ask and consider before signing on with a lender and a specific loan.

The Differences That Separate Short-Term from Long-Term Loans

Eligibility

It makes sense that more creditworthy borrowers would be considered for a long-term loan, thus making the qualification process for one more rigorous than that of a short-term loan. As mentioned previously, lenders face a greater risk of extending the payback period to a borrower. For you, that means the requirements you face in acquiring a long-term loan are a high credit score and impressive credit reports that reflect a history of good, consistent, and timely repayment practices.

There are lenders out there willing to issue loans to borrowers with less-than-impressive credit scores—but once again, it’s at a cost. If you have fair to poor credit, you can expect much higher interest rates with any type of loan, long term or short term.

This has especially been the case with online lenders who specialize in short-term loans for borrowers who have poor credit or lack credit altogether, like students, young adults, and recent graduates. These online lenders take on borrowers who have been turned away from conventional institutions like banks and credit unions and have a less stringent vetting process but at the cost of much higher interest rates.

Loan Amount

Long term loans are usually for higher amounts because it allows for more manageable monthly payments spread out over a more extended period of time. The amount of a long-term loan can be anywhere from $5,000 or as high as $500,000 (and higher). Borrowers use long-term loans for big purchases, like a home, a business, commercial real estate, a car, or tuition.

Alternatively, short-term loans are, on average, about $20,000 but can be as low as $2,000 and up to $250,0000. Borrowers can use short-term loans for just about anything. Sometimes, obtaining a short-term loan can allow you to get out of being financially strapped, make small repairs for a home, or even pay off debt.

The Costs of the Loans

The costs of short-term loans and long-term loans will be different with each lender. Lenders all use their own underwriting processes, establish their own interest rates, and opt to charge certain fees with their loans—or not. These additional costs can include things like late payment fees, origination fees, and other miscellaneous charges.

To determine the actual cost of the loan regardless of its term length, you can use online tools to calculate the cost of debt, making sure you read all of the lender’s fine print in what you can expect in the total amount of fees plus interest.

Approval Time

Short-term loans are often faster to acquire than long-term loans, making this the optimal choice if you’re in a hurry for financing. Long-term loans can take a few days or weeks, depending on the lender, and that all goes back to the greater risk because these loans are usually for larger amounts. Therefore lenders prefer to have a stricter qualification process.

Should I Choose a Short Term Loan or a Long Term Loan?

Again, it depends on your financial needs. For larger amounts that could fund things like inventory for a small business, a home mortgage, or a car loan, borrowers tend to opt for a long-term loan. The repayments are broken down into much more manageable monthly payments, often with a reasonably low interest rate and plenty of time to repay the amount.

Interest rates on short-term loans can be higher, although you’ll end up paying more interest back on a long-term loan, but there’s a benefit of quick funding for a smaller amount to get you by for your financial needs.

The only right answer is: choose the loan duration that best fits your needs. You’ll have to do some calculating, read the fine print, and do your research, but that’s what the loan process is all about.

Finance Guru

Finance Guru