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How Loan Terms Affect your Rate and Payment

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When you borrow money, you’ve agreed to pay an interest rate over a period of time. “Loan terms” can be confusing because the phrase is used for different aspects of a loan. It also has potential effects on your interest rate and payment. Let’s dive into understanding loan terms and what repercussions they may have on your loan.

Understanding Loans

Loans are borrowed funds that a lender expects a borrower to pay back with interest. The amount that you borrow is called the principal and the interest is the price that you pay to borrow money. Loans must be paid off in a set amount of time, which is known as the loan term.

Loans fall into two main categories: Secured loans and unsecured loans. A secured loan is where you secure money by using a physical asset as collateral. If you’re unable to repay your loan, the lender can use the asset to pay back your loan. Examples of secured loans are mortgages and auto loans.

Unsecured loans don’t hold assets as collateral. Lenders look at information like your credit score, credit history, income, and current debt to base lending decisions. If you’re unable to repay an unsecured loan, there are no assets that can be repossessed by the lender. Alternatively, the lender can report the default to the credit bureaus. This action hurts your credit score and affects your ability to get future loans. Unsecured loans typically have higher interest rates and lower borrowing amounts than secured loans. Examples of unsecured loans are student loans and personal loans.

Depending on the type of loan, you could have a term that lasts 12 months, 24 months, 36 months, 60 months and so forth. Each month, you will repay part of the principal back and some interest. The length of your loan term affects how much you must pay each month. The longer the loan term, the lower your monthly payment amount is. Let’s go into more about the factors that affect your monthly payment.

Factors of your Monthly Payment

Your monthly payment is calculated by looking at three main factors listed below:
  1. Total amount financed
  2. Length of the loan
  3. Interest rate
For example, let’s say you borrow $20,000 on a car loan for 36 months at a 6% interest rate. Your monthly principal and interest payment is $608.44. On 60-month loans, the monthly principal and interest payments are $386.66. 60-month loans or longer may seem beneficial because it makes monthly payments more affordable. However, it increases the cost or interest of the loan. In this scenario, if you were only looking at 60-month loans, you’d pay almost $1,300 more in interest compared to a 36-month term.

You can use our loan calculators to see how different terms and interest rates impact your monthly payment. 

Total Amount Financed

Prospective borrowers often ask about the interest rate of a loan when deciding whether or not to borrow from a lender. However, the interest rate as discussed above is only one factor that goes into computing your monthly payment. It’s not the component that has the greatest impact on your payments. The loan term and principal have a greater impact.

Let’s say you’re interested in a mortgage loan for a house that’s purchase price is $500,000. The interest rate on the loan is 6.5%, the loan term is 20 years and you want to borrow $400,000. Your principal and interest payments each month are $2,982 with these inputs. If you borrowed $350,000 instead, your principal and interest payments would be $2,609. Instead, if you extended your loan term to 30 years, it would make your principal and interest payments $2,529.

Different Loans to Meet Your Needs

Our purpose is to help guide our members to better financial lives. Join Power Financial Credit Union to find great rates, low to no fees and other benefits when you need personalized banking solutions. We offer a variety of loans, from mortgage loans to personal loans, to meet all your borrowing needs.