Loan Term: Time Periods and Specifics
Explanation of Loan Terms
A loan’s term can refer to several things. In most cases, the term is one of the following:
- How long the loan will last if you only make the required minimum payments each month
- Features of the loan that you agree to which are sometimes called the terms and conditions
Time as Loan Term
The first example is about time: How long will the loan last (until it is completely paid off with regular payments)? It can last for its entire term. Loans may be short-term loans or long-term loans.
A loan’s term may be easy to identify. For example, a 30-year fixed rate mortgage has a term of 30 years. Auto loans often have 5 or 6-year terms, although other options are available (auto loans are often quoted in months, such as 60-month loans). However, loans can last for any length of time that a lender and borrower are willing to agree on.
Sometime before the end of a loan’s term, the loan must be paid off or refinanced. When you get a loan (such as a 5-year auto loan), you often have a required monthly payment. That payment is calculated so that you’ll pay off the loan entirely over the course of the loan’s term. At the end of the 5th year, your last payment will cover exactly what you owe. The process of paying down debt this way is called amortization.
Why It Matters: A loan’s term is important: it affects your monthly payment and your total interest costs. A longer term means you’ll pay less each month, so it’s tempting to take loans with the longest term available (for example, you might be drawn to the 72-month loan instead of the 60-month loan). However, a longer term also means you’ll pay more in interest charges over the life of that loan. In other words, you’ll pay more for whatever you’re buying (the price tag doesn’t change, but the amount you pay does).
Loan Periods: Loan periods are also related to time, but they aren’t the same as your term. Depending on how the language is used, a period might be the shortest period of time between monthly payments or interest charge calculations. In many cases, that’s one month. For example, you might have a loan with an annual rate of 12%, but the periodic (or monthly) rate is 1%.
The term loan period can also refer to times at which your loans are available. For student loans, a loan period might be the Fall or Spring semester.
Terms and Conditions of a Loan
Loan terms can also be the characteristics of your loan, which are described in your loan agreement. When you borrow money, you and your lender agree to certain things which are the "terms" of your loan. They’ll provide a sum of money, you’ll repay according to an agreed upon schedule, and if something goes wrong each of you has rights and responsibilities that are listed in the loan agreement.
Some common terms that are worth paying attention to are listed below.
Interest Rate: How much interest is charged on your loan balance every period. The higher the rate, the more expensive your loan. It’s also important to find out if your loan has a fixed interest rate or a variable rate that can change at some point in the future. Rates are often quoted in terms of an annual percentage rate (APR), which might account for additional costs besides interest costs.
Monthly Payment: Your monthly payment is often calculated with the length of your loan and the interest rate. However, there are a variety of ways to calculate your required payment (for example, credit cards often calculated based on a small percentage of your balance). Make sure you know how much you’ll pay each month and if that amount will ever change. You need to be sure that the payment fits within your budget.
Prepayment Penalties: Cutting your interest costs is often a good idea. If you can pay off your debt faster than is required, you’ll avoid wasting money. Find out if there’s any penalty for paying off loans early or making extra payments. Especially when it comes to high-cost loans like credit cards, paying more than the minimum is wise.
Balloon Payments: Some loans don’t get paid down over time; you only pay interest costs or a small portion of your loan balance. Unfortunately, that means you’ll need to come up with a large balloon payment (or refinance the loan with another large loan) at some point in the future. Make sure you know about this long before that payment is due.