When it comes time to finance your next big purchase, you’ll face a number of important decisions. The first, and arguably most crucial, will be how you finance. For instance, if you plan to pay off your purchase within 30 days, you might consider charging it to your credit card to earn cash back or miles. For any purchase you intend to pay off over months or years however, credit cards aren’t really the way to go.
Why? Well, it comes down to interest. Your credit card likely charges an APR of 10% to 25%, and those double-digit rates can equal hefty interest fees in just a few months. On the other hand, those with good credit can often expect personal loan rates below 15%, and even bad-credit installment loans can have lower interest rates than credit cards, making loans the possible choice for financing anything you need to repay over time.
After you’ve decided how you’re going to finance a purchase, you still have a number of choices to make, not the least of which is how long you need your loan to be. Not only will this impact how long it takes you to pay off your loan, but the length of your loan will also influence your monthly payment and the total cost of your loan.
The Longer the Loan, the More Interest You Pay
While loan shopping, it’s easy to be hyper-focused on minimizing the size of the monthly payment or diligently hunting down the lowest APR. One factor frequently overlooked however, is the length of the loan itself – which can be an expensive mistake. The number of months you actually spend making monthly payments can have as much of an impact on the total cost of your loan as the rate itself.
The reason comes down to the nature of compound interest, the most common form of interest charged by financial institutions. In essence, compound interest calculates your interest fees at predetermined intervals (typically monthly or yearly, though many credit cards calculate it daily), using your most current balance. So, as you pay down your principal each month, the size of your interest payment decreases.
Since shorter loans have larger monthly payments than longer loans, your principal decreases at a much faster rate. For example, consider a $10,000 loan that charges 15% interest. If a hypothetical borrower, Ann, repays the loan over two-and-a-half-years (30 months), she would have a monthly payment of $402, and she would pay a total of $2,054 in interest fees over the life of the loan.
At the same time, if a second hypothetical borrower, Andy, takes out the same size loan at the same rate, but takes twice as long to repay the loan, making payments for five years, his lower monthly payment would be approximately $161. While that may seem lovely on the surface, his lower monthly payment comes with a significant cost. Andy would pay a total of $9,360 interest fees – meaning he would pay almost as much in interest fees as he originally borrowed.
Finding the Best Loan Terms for You
A great way to determine the best loan terms for you, including monthly payments and loan length, is to use a debt calculator to crunch the numbers. You can manipulate any of the loan terms, including the loan length, to find the best fit. The ideal loan terms will provide an affordable monthly payment, while also minimizing the amount of total interest you pay over the life of your loan.
Of course, there is a limit to the benefits of shortening your loan length. Installment loans are specifically designed to be long-term products. Most loans less than six months long are actually short-term (sometimes called “payday” loans). These loans tend to have particularly high interest rates, regardless of your credit score.
Instead of taking on a short-term loan, you may want to look into 0% APR credit card offers to finance purchases you can pay off within 12 to 18 months. You can even use credit cards to consolidate your existing credit card debt through balance transfers, and you can spend over a year interest-free with the best balance transfer credit cards. However, it’s important to pay your total balance before the end of the introductory term to avoid paying any interest.
Fewer Payments Mean Fewer Chances to Pay Late
Although minimizing the amount of interest you pay is definitely a strong motivator to choose a shorter-term loan, it certainly isn’t the only reason to do so. For one, the less time you spend obligated to your loan payments, the more opportunities you’ll have to use your money for other investments, including paying off other debt or boosting your retirement savings.
Obtaining a shorter-term loan can also limit the room you have for potential mistakes. Even those with the best of budgets (or intentions) can occasionally forget to pay a bill now and then – but those little mistakes can be costly. Your payment history is a major factor of your credit score, and each missed payment can have a significant negative impact. And those impacts can be long-lasting, as time is the only effective way to erase the mark on your credit from a missed payment.
You may also find other benefits of paying off your loan sooner, depending on the type of loan. When it comes to auto loans, for example, paying off your loan early usually means your car has had less time to depreciate than it otherwise would, and can be sold or traded in for a better value. A longer auto loan, on the other hand, would mean your car depreciates a lot more while you’re making payments, and could eventually be worth even less than you owe on it.
Another option to reduce the interest you pay – as well as the risk of falling behind or getting underwater on your loan – without taking on a shorter loan, is to pay more than your required payment or make multiple payments each month. Your payment goes first to your interest fee, then to your principal, so paying more each month can reduce your balance at a faster rate.