How Do Loan Terms Impact Your Interest Rate?
Find The Best Deal By Considering How The Length Of A Loan Impacts Interest
Taking out a loan for a car or a home is a big process that involves many important choices. Although you can’t simply choose whatever interest you prefer – after all, everyone would just choose 0 percent – you can still choose the term, or length, of your loan, which can have a big impact on the interest rate.
“In general, the longer your loan term, the more interest you will pay,” states the Consumer Financial Protection Bureau website consumerfinance.gov. “Loans with shorter terms usually have lower interest costs but higher monthly payments than loans with longer terms.”
Because of the reduced interest, shorter-term loans will typically save you money overall. This is due to the fact that a reduced repayment period means that you are paying interest for a shorter amount of time. Second, the interest payments that you do make will typically be at a lower interest rate than those offered by long-term loans.
While this may be the general trend, the size of the effect depends on the specifics of each loan. For example, a homebuyer on a tight budget who is comparing a specific long-term and short-term loan might find that the lower interest rate offered by the short-term loan does not result in sufficient savings over the lifetime of the loan to incentivize managing the higher monthly payments.
Kiplinger Senior Editor Anne Kates Smith explored the impact that a higher monthly payment would have on a mortgage holder’s finances if the person chose a 15-year home loan over a 30-year home loan.
“You can save a lot of interest by choosing a 15-year loan over a 30-year-about $63,000 after taxes on a $200,000 loan for someone in the 28 percent tax bracket,” she states. “But ask yourself whether you can really afford the higher monthly payment – in this case, $1,420 versus $955.”
The difference between those two monthly payments is dramatic, and choosing the higher payment can result in a serious downgrade in living standards for people on a tight budget. People in this situation would have to look at all of their monthly expenses to see what they would need to sacrifice to come up with the extra money, in order to gain a clearer picture of feasibility.
Even if you aren’t on a tight budget and could still afford to maintain your normal routine while making the larger monthly payment, such as eating out twice a month and paying your children’s sports team dues, that money might be better spent elsewhere.
“Have you maxed out your 401(k) and built up an emergency fund? Paid off credit cards? Funded insurance policies and, if you desire, college savings?” asks Smith. “If you haven’t, choose the 30-year loan.”
Furthermore, if you have done all those things, you might still be better off choosing a 30-year loan so that you have more money each month to put into an investment account. Having a conversation with your financial institution can help you determine what interest rates you qualify for with different loan terms. Then you can work together to compare how much interest you could potentially save with a shorter loan vs. how much you could save in an investment account over the same time period. With those calculations complete, you can feel confident in the loan term you choose.
Published by Cumberland County Federal Credit Union
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