Short Repayment Terms vs. Longer Loans: How They Work and Which is Right For You

November 06, 2020
Nadav ShemerByNadav ShemerNov. 06, 2020
Short repayment terms, or a longer loan with lower monthly payments? Which is right for you?
The monthly cost of a personal loan is determined by 3 factors: loan amount, interest rate, and loan term. The bank decides the interest rate based on your credit score and other factors (and tacks on fees to form your APR). Assuming we hold loan amount and interest rate constant, the size of your monthly payments will be determined by the duration of your loan, also known as the loan term.

Understanding the Differences Between Short and Long Terms

The best way of comparing the difference between a short and long term is by looking at the numbers. There are plenty of free online tools that can do the calculations automatically. Here's an example, using a $10,000 loan with 5% interest and 1-year loan term. 

Each month, you pay interest on your remaining balance. The formula for calculating monthly interest is: Balance x Interest ÷ 12 (the number of months in a year). In Month 1 of our example, the formula is:

(10,000 * 0.05) / 12 = 41.67

Now in order to repay the $10,000 loan amount, you’ll need to pay an average of $833.33 in principal each month. But because your balance decreases following each monthly payment, your interest payments also decrease each month—and your principal payments increase.

 Here’s the full amortization schedule:

MonthPaymentPrincipalInterestTotal InterestBalance

Now that we understand how monthly payments are calculated, let’s look at a few examples. In each of the tables below, we hold the loan amount and interest rate constant, and compare loan terms of 1, 3, 5, and 10 years by the size of the monthly payment and total interest paid to the lender.

Table 1: Loan Amount = $5,000; Interest Rate = 5%

Loan AmountInterest RateLoan Term (years)Total Interest PaidMonthly Payment

Table 2: Loan Amount = $5,000; Interest Rate = 10%

Loan AmountInterest RateLoan Term (years)Total Interest PaidMonthly Payment

Table 3: Loan Amount = $20,000; Interest Rate = 5%

Loan AmountInterest RateLoan Term (years)Total Interest PaidMonthly Payment

Short Terms vs. Long Terms: Pros and Cons

Short Terms
Lower total interestHigher monthly payments
Lower overall paymentsMore pressure on monthly budget
Quicker to become debt-freeHigher APRs
Long Terms
Lower monthly paymentsHigher total interest
Less pressure on monthly budgetHigher overall repayment
Lower APRsSlower to become debt-free

In the examples in the previous section, notice the difference in monthly payment as the loan term changes. Not surprisingly, lower loan amounts and lower interest rates translate to lower monthly payments. But, holding loan amount and interest rate constant, shorter terms equal higher monthly payments (but less total interest paid) and longer terms equal lower monthly payments (but more total interest paid). Table 3 offers the most extreme example: a 1-year term costs 8 times more each month than a 10-year term, but costs 10 times less in total interest paid over the life of the loan.

While we held the loan amount and interest rate constant for the sake of the examples above, the reality is that most lenders factor in amount and term when determining the rate. A higher loan amount often translates to a lower interest rate, because the lender can collect more interest overall. Short-term loans usually have higher interest rates than long-term loans, not to mention that they put the borrower at higher risk of missing payments and suffering the consequences.

When Is a Shorter Term a Good Idea?

As a general rule, you should always aim to pay off debts as quickly as you’re able. The shorter a loan, the shorter the number of months or years in which you’re indebted to your lender—and the less you end up paying overall. Therefore, if you’re certain that you can afford the monthly payments associated with a shorter loan, and still have enough money left over for food, rent/mortgage, and all those other important things, then a short term could definitely be the right option.

When Is a Longer Term a Good Idea?

If you aren’t confident of meeting the monthly costs of a short-term loan, then get a longer term with a monthly payment you can afford. If you take a shorter loan and end up missing monthly payments, you may be subject to additional fees and—in the case of a secured loan in which you put up an asset such as a car or savings account as collateral—you may end up losing the asset. By taking out a long term with affordable monthly payments, you trade the inconvenience of paying higher costs over the life of the loan for the comfort of being able to sleep well at night.

What Now?

There are hundreds, if not thousands, of lenders in the United States, offering personal loans with terms ranging from one month to 180 months. Why is there such a wide disparity when it comes to loan terms? The simple answer is that each borrower is different, and what works for one borrower may not work for another.

When comparing the top personal loan companies, it’s important to shop around for the right lender, to be realistic about what you can afford, and to prepare a detailed budget to guide you on your ideal level of monthly payments. It can be tempting to take out the shortest term offered to you by your lender, or to go for the absolute lowest monthly payment (and therefore the longest term), but the truth is the most extreme option isn’t always the right option.

So, what is the right loan term for you? Ultimately, only you can decide. If you do your due diligence, make calculations and research personal loans, you should be able to figure out what works for you.

About The Author

Nadav ShemerByNadav ShemerNov. 06, 2020
Nadav Shemer specializes in business, tech, and energy, with a background in financial journalism, hi-tech and startups. He enjoys writing about the latest innovations in financial services and products.
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