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Key Points:
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Long-term loans provide borrowers a lower monthly payment
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Consumers should determine if the loan payment fits into their personal budget
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Borrowers will pay more in total interest costs if they take out a longer-term loan
Consumers take out personal loans to meet financial needs, and the loan term has a big impact on your monthly payments and interest costs. This article defines personal loans, and how the loan term impacts the borrower’s financial situation. You review some examples, and learn about strategies to decide on the personal loan term length.
Personal loans do not require you to provide collateral for the loan.
What Is a Personal Loan?
Consumers use personal loans for a variety of purposes, and both traditional banks and online lenders offer personal loans. The typical personal loan has a fixed interest rate, with a fixed schedule of monthly payments. Personal loans do not require you to provide collateral for the loan, and repayment is secured by the borrower’s ability to pay.
Top Personal Loan Providers
Personal Loan Term Length
The term length is the length of time that your loan is outstanding. How long can you get a personal loan for? Typical personal loan terms are from one to seven years, depending on your lender. The personal loan terms you choose will help to determine your monthly loan payment, and the total interest charges over the life of the loan.
How the Loan Term Impacts Costs
When you borrow over a longer period, the loan repayment is spread over more months. As a result, your monthly payment will be lower. However, borrowers pay more total interest costs on longer term loans. You’ll pay more interest on a five-year loan vs. a three-year loan, and the longest term personal loan will be the most costly.
A short-term loan requires you to repay more of the principal amount each month, meaning that your monthly payments will be higher. However, the total interest cost is lower on a short-term loan.
Personal Loan Examples
You can use this personal loan calculator to determine the cost of your loan, based on the loan term and the interest rate. These examples illustrate the impact of your loan’s term and the interest rate.
Assume, for example, that you borrow $10,000 for 5 years at a 16% interest rate. Your monthly payment is $243, and the total interest cost is $4,591.
Now assume a 7-year loan term, instead of 5 years, for the $10,000, 16% interest rate loan. The monthly payment is only $199, but the total interest cost is $6,684. By extending the loan term by 2 years, you will pay $2,093 in additional interest costs.
The last example is a $10,000, 5-year loan at a 12% interest rate. The monthly payment is $222, which is lower than the 5-year loan at a 16% interest rate payment. Total interest paid over the loan term is $3,346, an amount $1,245 lower than the 16% interest rate loan.
To summarize, extending the loan term at the same interest rate generates a lower monthly payment but higher total cost in interest. Lowering the interest rate without changing the other loan terms reduces the monthly payment and the total interest costs.
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Interest Rates on Personal Loans
Your credit score is the biggest factor used to determine the interest rate charged on a personal loan. The credit score is based on the amounts the consumer has borrowed over time, and if loan payments were made on time.
A lender will also consider your annual income, and what percentage of your net income after taxes is required to make monthly payments. A higher income puts you in a better position to repay a loan. Getting approved for a larger loan may be more difficult, because the required monthly payments will be larger.
Compare the interest rates offered by different lenders. If the interest rate you’re offered seems too high, apply for a lower loan amount.
Based on brands we’ve reviewed on Lendstart, the average annual percentage rate (APR) for personal loans may vary from 11.6% for an excellent credit score to over 30% for a poor credit score.
How to Pick A Personal Loan Term Length
How long are personal loans? To determine loan term length, review your monthly budget and consider why you’re taking on a personal loan.
1. Assessing Your Personal Budget
The personal loan monthly payment must fit into your monthly budget, so that you can make all payments on time and build a better credit score. If you don’t have a budget, use this budget template calculator to create one.
Start with your monthly income, which is your after-tax salary or wages, plus any additional income you earn. The template separates spending into three categories: 50% for essentials, 30% for wants, and 20% for savings.
A peronal loan will be listed in the financial obligations section of the template. As you research personal loan lenders, verify if the monthly payment they offer you will fit into your budget. As explained above, extending the term of a loan lowers the monthly payment, but increases the total interest costs.
Using an automated template saves you time and makes the budgeting process easier and more reliable. When you know where you stand financially, you can make more informed decisions.
2. Consider the Purpose of Your Loan
Personal loans can be used for any purpose, and how you use the money you borrow may impact the term of your loan. Consider these two scenarios:
Paying for Wedding Expenses
Let’s assume that a couple uses a personal loan to help pay for a wedding. In addition to the personal loan, the wedding requires the couple to use the cash balance in their emergency fund.
In this case, the couple may choose a longer loan term with a smaller monthly payment, so that the couple can use dollars in the monthly budget to rebuild the emergency fund balance.
Covering Medical Expenses
Some people who incur medical expenses need time to recover before returning to work. If you’re out recovering from an illness, you may not be earning a salary, or generating income as a freelancer/ independent contractor.
For these reasons, an individual may choose a longer loan term with a smaller monthly payment, so they can fit the payment into a budget with less income.
3. Applying for a Personal Loan
If you’re interested in applying for a personal loan, start by checking your credit score. Start comparing personal loan offers from lenders. Your credit score will help the lender determine the interest rate you’re charged on a personal loan.
Review the rates, terms and conditions presented by each lender, including the dollar amount of the loan, the loan term, and the interest rate. Use the discussion above to determine the loan term that may be the right fit for you.
Finally, choose a lender and complete the formal loan application, which will include questions about your income and employment.
The Bottom Line
The loan term you choose has a big impact on the dollar amount of your monthly payment, and on the total interest costs of the loan. Research different lenders and compare the loan terms offered by each lender. Consider your personal budget and how much income you generate.
Informed decision-making is the best strategy to improve your finances.
If the interest rate and amount of my loan stay the same, but I extend the loan term, what is the impact?
If you extend the loan term, your monthly payment will decline, but the total interest costs will increase.
If the loan term and dollar amount stay the same, but I’m able to borrow at a lower interest rate, what is the impact?
Both your monthly loan payment and the total interest costs will decline.
What is the advantage of using a short-term loan?
If the borrower can afford higher monthly payments, the individual will pay less in total interest costs using a short-term loan.
Article Topics
Personal Loans
Kenneth Boyd is a four-time Dummies book author, including the book Cost Accounting for Dummies. Ken writes, blogs, and provides video content on business topics.
