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Key takeaways:
- Loan terms can refer to the length of a loan, as well as to other conditions you agree to when borrowing money.
- Loan length impacts monthly payments and the total cost of borrowing, but so do interest rate and loan type.
- It’s important to understand how all these factors affect the cost of borrowing money so you can make an informed decision.
But the phrase “loan terms” doesn’t just refer to how long the loan lasts. It also includes all the conditions outlined in your loan agreement, like your interest rate, payment schedule, fees, and any penalties. That’s why it can sometimes be confusing.
To make smart borrowing decisions, it’s important to understand how these loan terms affect your total cost and monthly payments. In this guide, we’ll break down what loan terms mean, how they work, and what to expect if you’re applying for a 60-month loan or a shorter-term product.
Understanding Loans
A loan is a sum of money you borrow from a lender and pay back with interest. Your lender will refer to the amount you borrow as the principal, while the interest is the price you pay to borrow money. The initial sum you borrow, or the principal, is the basis for interest calculations and repayment schedules.When you borrow the money, you’ll agree to repay it in a set amount of time, which is known as the loan term or the length of a loan. For mortgages, a term of 15 or 30 years is common. If you’re shopping around for personal or auto loans, 60-month loans are a common option, but you can find terms that range from one to seven years.
Loans fall into two main categories.
Secured Loans
With a secured loan, you’re using a physical asset as collateral. This reduces risks for the lender because they can repossess the collateral asset to recover your outstanding loan balance if you become unable to make your payments.Examples of secured loans are mortgages and auto loans. Thanks to the personal assets used to secure the loan, you can typically get a better interest rate.
Unsecured Loans
Unsecured loans don’t hold assets as collateral. Instead, 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.
Interest is usually higher on unsecured loans, and lender will let you borrow less compared to secured products. Examples of unsecured loans include student loans and personal loans.
Common Loan Lengths
Depending on the type of loan, you could have a term that lasts 12 months, 24 months, 36 months, 60 months or even more.Borrowing for a longer period usually means your monthly payments will be lower. However, you'll accumulate more interest over time.
On the other hand, short-term loans have higher monthly payments, but you’ll end up spending a lot less on interest.
If you want to get out of debt fast and reduce what you spend on interest, applying for a short-term loan makes sense. Choosing a longer term would be a better decision if your goal is to keep your monthly payments low and don't mind spending more on interest over time.
Understanding your loan terms helps you manage your financial obligations and plan your budget effectively. Be aware that longer loan terms can lead to more debt accumulation if you don’t manage your finances carefully.
Which Factors Impact Your Monthly Loan Payment?
Your lender calculates your monthly payment by looking at three main factors:
- Total amount financed
- Length of the loan
- Interest rate
If you were to borrow that same amount at 6% with a 60-month loan, you would only pay $386.66 every month. A 60-month loan (or longer) may seem like a good option because it lowers your monthly payments. However, a longer term increases the total cost of your loan since you’re making payments for longer.
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. We recommend using our loan calculators to see how different terms and interest rates impact your monthly payment.
Total Amount Financed
We often see prospective borrowers asking about the interest rate of a loan when making their decision.However, the interest rate is only one factor that goes into computing your monthly payment. The amount you borrow, or principal, has a much greater impact on what your monthly payments will be.
Let’s say you’re interested in a mortgage loan for a house with a purchase price of $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 monthly mortgage payment would be $2,982.
If you’re able to save up for a larger down payment on that same house and borrow $350,000 instead, your mortgage payments will drop to $2,609.
Length of the Loan
In the example above, financing that same home over a longer term can further reduce your monthly payments.If you can come up with a down payment large enough so that you only need to finance $350,000 at 6.5%, borrowing over a 30-year term rather than a 20-year term would mean paying $2,529 a month.
Extending the length or term of your loan can make your payments fit within your budget more easily. However, you’ll end up spending more on interest and loan fees over the years.
To go back to the mortgage example, borrowing $350,000 over 20 years is the equivalent of paying around $276,281 in interest over the years. That same loan on a 30-year term equals to paying around $446,405 in interest.
Interest Rate
Your interest rate is another major factor influencing your monthly payments. Does the loan term affect the interest rate? The answer is yes, but there is more that goes into figuring out your interest rate.Here’s what lenders typically look at:
- Your financial profile. A strong credit history and low debt-to-income ratio will help you secure a better interest rate.
- The loan type. As discussed above, secured loans usually come with a lower rate because lenders perceive them as safer.
- What are you financing? There is an important distinction between loans like mortgages, where the asset (your home) will likely appreciate over time, and products like recreational loans or used car loans, where the asset can depreciate quickly.
- The lender. Interest rates and fees vary from one lender to another, which is why you should shop around and compare your options.
If you’re financing $10,000 at both rates, you’d pay $192 a month and end up spending around $1,560 in interest over the 60 months of the loan term with the credit union.
If you decide to borrow from the bank instead, you'll pay around $200 a month for that same car. Over the 60-month period of the loan, you'll pay around $2,025 in interest.
Make an Informed Decision With Power Financial Credit Union
Before you borrow money, it's important to review your options and understand how factors like your loan's duration, interest rate, and total amount you borrow will affect your payments. You should consider your current finances and goals to pick the best option for your needs.Power Financial Credit Union can help. We offer diverse lending options, and our loan experts are here to explore lending products with you.
Start by learning more about our loan products, including mortgages, auto loans, personal loans, student loans and more.