Make sure you understand how a longer or shorter term affects your loan.
- Personal lenders offer a choice of repayment terms.
- Your repayment term affects total borrowing costs.
- Your monthly payment is also impacted by the repayment schedule you have chosen.
When you take out a personal loan, chances are you have a choice about your repayment term. Depending on your lender, you may be able to decide to pay off your loan in as little as a year or two, or you may be able to opt for a repayment schedule that spans 10 years or more.
This decision may not seem that big, but the reality is that your timeline for paying off your debt can profoundly affect your finances. Here’s why.
Your payment schedule determines monthly payments and total costs
The simple reason your repayment schedule is so important is that the time you take to repay your loan affects:
- The amount of your monthly payment.
- The total amount you will pay in interest over time to borrow.
There is actually an inverse relationship between these two factors, so there is a key trade-off you will need to consider when borrowing.
If you choose a shorter repayment term, each monthly payment you make will be higher. This gives you less flexibility in your monthly budget because you’ll spend more money paying off your loan sooner. But because you’ll be paying interest for a shorter period, your financing costs – and therefore total borrowing costs – are lower.
The opposite is true if you opt for a personal loan you will take longer to repay. With more time spent paying interest, your loan will cost you more in the long run. You will usually also have to pay a slightly higher interest rate for a loan with a longer repayment term rather than a short one, which only adds to the additional costs you will incur.
Of course, your monthly payments will be lower when you take longer to pay off your debt, which means you may be able to accomplish more with your money over the term of the loan rather than sending larger payments to creditors. .
To understand just how big an impact your payment schedule can have, consider a $10,000 loan. If you opt for a two-year repayment term and your interest rate is 7%, you’ll pay about $746 in interest over the life of the loan, but each monthly payment would be $448, a pretty steep amount. .
If you took out the same $10,000 loan to be repaid over five years and your interest rate was 8% instead, you would pay $2,165.84 in interest, but each monthly payment would be much more affordable of $203.
Should you choose a longer or shorter loan repayment term?
As you can see, you would save a lot of money by going for the shortest possible loan repayment term. But you also have to take into account that you will be tying up a lot more money each month.
In most cases, it is better to choose the shortest repayment term and the cheapest loan, because the rate of personal loans can be close to or higher than the return on investment you could obtain with a safe investment. In other words, you’ll probably be better off paying off your loan early rather than making smaller payments and investing the difference. You also can’t deduct interest on personal loans from your taxes in most cases, so there’s no real benefit to paying interest any longer.
Ultimately, though, you want to make sure your monthly payments are affordable. If there’s a chance you can’t comfortably cover the payments with a short-term loan, you might not want to take that risk. So take into account your financial situation, your goals and your budget and make the choice that suits you best.
The Ascent’s Best Personal Loans for 2022
The Ascent team has scoured the market to bring you a shortlist of the best personal loan providers. Whether you’re looking to pay off debt faster by lowering your interest rate or need extra money to make a big purchase, these top picks can help you reach your financial goals. Click here for the full rundown of The Ascent’s top picks.