Loan terms significantly affect the cost of credit by influencing both the monthly payment amount and the total interest paid over the life of the loan.
How Loan Terms Affect Cost of Credit
- Loan Term Length : Longer loan terms spread payments over more months, which lowers monthly payments but increases the total interest paid. This happens because interest accrues over a longer period. For example, a $15,000 loan at 7.75% APR over 10 years results in monthly payments of $180.02 but a total cost of $21,602.40, whereas the same loan over 3 years has higher monthly payments of $468.32 but a lower total cost of $16,859.52
- Interest Rates : Generally, shorter terms have lower interest rates because they pose less risk to lenders, reducing total interest costs. Longer terms often come with higher interest rates, further increasing the total cost of credit
- Principal Amount : The amount borrowed (principal) directly impacts total interest paid. Larger loans mean more interest over time, and lenders may impose stricter terms or higher rates for bigger loans due to increased risk
- Fees and Other Charges : Loan agreements may include fees such as origination, ongoing, or late payment fees, which add to the total cost. These fees can be affected by the loan term and repayment behavior
- Repayment Frequency : How often you make payments (weekly, monthly, etc.) can slightly affect the total interest paid, with more frequent payments potentially reducing interest accumulation
Summary
Choosing a longer loan term reduces monthly payments but increases the total cost due to more interest accrued and often higher rates. Conversely, shorter terms increase monthly payments but reduce total interest paid. Borrowers should balance their ability to make monthly payments with the desire to minimize overall borrowing costs. Credit scores also influence loan terms and interest rates, with poorer credit typically leading to higher costs
