How Do Loan Terms Affect the Cost of Credit?

A loan term is the amount of time you've got to pay your installment loan off. You'll agree to a fixed term before accepting a loan. Other types of personal loans, such as credit cards, don't have terms.

For smaller loans, you may select just a term lasting just a year or two. For larger loans, like a mortgage, you may choose a term of 30 years or even longer, in some cases.

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What Is the Cost of Credit?

Banks aren't philanthropists — they don't lend out money for free. You'll pay a price in the form of interest and fees. The more you borrow, the more you'll pay in interest.

When you open an installment loan, you'll be paying back more than just the principal. When banks figure out your monthly payment, they bake in the interest they expect to receive.

Cost of Credit: An Example

Say you take out a $10,000 personal loan at 8% APR with a 48-month term. Each month, you'd make a payment of $244.13. By the end of the loan, you'd have paid $11,718.20 for the loan,​​ meaning the cost of credit was $1,718.20.

Your specific cost of credit depends on the term length and the loan amount, but it also depends on your credit score — which largely influences the loan's interest rate — and any origination fees.

Why Do Loan Terms Matter?

Loan terms play a large part in:

• How much you'll pay per month

• How much you'll pay in interest

If you'd like to pay as little as possible, choose the longest possible term. The only issue is that the longer you take to pay off your loan, the more you'll pay in APR. Interest increases for the luxury of lower monthly payments — in other words, it takes more time to pay off your loan.

In truth, though, the amount you pay in interest is up to you no matter your term length. Unless your loan has prepayment penalties, you can pay off a loan early to reduce your cost of credit.

For example, a $15,000 loan with 10% APR would result in:

• $824.86 in interest for a 12-month loan

• $1,627.17 in interest for a 24-month loan

• $4,122.34 in interest for a 60-month loan

If you pay off your loan early, though, you'll save on interest payments.

Here's another look at the above example again

If you pay twice the agreed monthly payment on the $15,000 loan with 10% APR you'd pay:

• $432.43 in interest for a 12-month loan

• $787.76 in interest for a 24-month loan

• $1,766.69 in interest for a 60-month loan

As you can see, that's dramatically lower than if you had made the minimum payment each month.

How Loan Terms Change the Cost of Credit

Here's another look at what a $10,000 loan with 8% interest would look like.

Take another loan example — $10,000 at 11%.

• 1-year term: ~$884/month, ~$605 in interest

• 2-year term: ~$466/month, ~$1,185 in interest

• 3-year term: ~$327/month, ~$1,785 in interest

• 5-year term: ~$217/month, ~$3,045 in interest

How To Choose the Right Loan Term

Examining your budget to decide between a short-term vs. long-term loan is vital before opening a new account.

How much money can you spare on extra monthly payments? Ideally, you'll choose a term that is well below that number. Missing payments hurt your credit score, so you should ensure that you can easily handle the financial constraints of a new loan.

Also consider if you truly need the loan. What are you trying to buy that you can't wait until you've saved the money? Is it a wise investment?

Use a loan calculator to reveal the true cost of your loan. That's the amount of money you're paying to avoid waiting. Not to say there aren't plenty of loan-worthy situations — just be sure yours is one of them.

Common Mistakes to Avoid When Choosing a Loan Term

These are some of the most common mistakes that you shouldn't overlook when you're taking on a new loan.

• Don't forget about additional fees: When choosing a loan term, you may be tempted to focus solely on the monthly payment and ignore the total interest and fees associated with a lengthy installment plan. Some lenders even surcharge the APR for a longer term.

• A loan costs less the faster you pay it off: It's not "wrong" to choose an extra long term if you plan to throw more money towards the loan and pay it off early — provided there's no early payoff penalty.

• Shop around for the best rates: Many lenders will prequalify you, giving you a peek at your unique APR and term options.

FAQs

What is a loan term?

A loan term is the length of time you have to pay back your loan. Think of it as the lifespan of the loan.

What is a term loan?

A term loan means a loan that includes a "term," or a predetermined repayment schedule. In other words, it's not a revolving loan like a credit card or other line of credit, for example.

How does a longer loan term affect the cost of credit?

A longer loan term affects the cost of credit in that you'll often pay more interest the longer your loan is open.

Is it better to get a short or long-term loan?

The answer to whether it's "better" to get a short- or long-term loan depends on your situation and affordability of monthly installments. That said, the shorter the loan, the better to avoid interest fees.

How do monthly payments change with different loan terms?

Monthly payments either increase or decrease with different loan terms. If you borrow a chunk of money, you can either pay it back sooner — with bigger monthly installments and fewer interest payments, or later — with more manageable monthly installments but more interest payments.

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