A staggering 176 million Americans are carrying around credit cards. Those with personal loans top 19 million.
You might already be one of them.
But do you really understand how debt works? What’s more important while applying for a loan, the interest rate or the length of the loan term? Do long term loans actually cost more in the long run?
Let’s find answers to all these questions.
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Benefits of Long Term Loans
One of the main benefits of long term loans is the ability to take out a larger loan amount. This is why home loans typically have 30-year (or longer) loan terms. Paying off $350,000 for your dream home in 5 years would be virtually impossible for the average person, but becomes more manageable over 30 years.
Let’s look at a couple of other benefits of long term installment loans.
Lower Monthly Payments
Because the loan term is spread out over a longer period of time, you’ll be required to pay less on your monthly payments. That isn’t to say you can’t pay extra if you’d like to avoid accumulating extra interest, but if you can’t afford the shorter-term payment, taking a longer-term loan could be helpful.
This one can actually go either way. A long-term loan is riskier for the lender because they have to wait longer to be repaid. For that reason, a higher interest rate is sometimes attached.
However, because of the risk factor, these types of loans are often secured with collateral. Mortgages and real estate loans are a good example. These carry some of the lowest interest rates in the industry because the lender has the option of seizing the property if you don’t pay back your loan. On the other hand, there are title loans that can be obtained by temporarily surrendering the title of your vehicle. This helps you to keep your vehicle with you while you are repaying the loan.
Will You Pay More in Interest?
Yes, and this may hold true even if your longer loan term comes with a lower interest rate. Why? Most loans are amortized monthly, which means that every month that goes by, more interest is piled on top of your principal.
Let’s look at an example. Say you borrow $30,000 at 7% interest with loan repayment terms of 5 years. You’ll pay $594.04 per month and at the end of 5 years (assuming you made no extra payments) you will pay $5,642.16 in interest.
Contrast that with borrowing $30,000 at 6% interest but a repayment period of 8 years. You’ll get the benefit of a lower monthly payment, $394.24, but the total interest over the life of the loan will be $7,847.32. That’s $2205.16 more in interest even though the interest was a whole percentage point lower.
Should You Take Out a Long Term Loan?
So the moral of the story is to go for the shortest loan term possible, right? Not always.
Check out using this strategy for our previous example. Choose the 8-year loan at 6% but pay the 5-year loan payment. By adding that extra $200 per month, you’ll pay it off 3 years and 1 month sooner and pay only $4,661.73 in interest (assuming the loan doesn’t come with prepayment penalties). So if you’re disciplined about paying that extra amount you can save yourself about $1,000 with this technique.
If you’re looking at long term loans because you need cash now, check out these things to do when you need money. You might be able to avoid that loan altogether.