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Why you should get the shortest term loan possible

September 30, 2010

The term of a loan is an important and often “underlooked” factor when applying for a new loan. But because the loan’s term can affect the total amount of interest paid as well as the affordability of each repayment, it should be carefully considered before accepting the loan.

There are two effects to the loan’s term, which can be misleading when the borrower is only looking at the repayments. First, the total interest paid increases with the duration of the loan. If there’s a 10% interest rate charged on a $5,000 loan, then over a ten-year term almost twice as much interest will be paid as there would be over a five-year term.

This higher interest effect is masked by the other effect of a loan’s term, which is that a longer term spreads the repayments over more months. It’s simple mathematics: the more months divided into the principal, the lower the payment amount will be. If there is a $2,400 loan, the repayments will be $200 per month for a 12-month loan, but $100 for a 24-month loan. This means that although the total amount of interest charged—the cost of borrowing the money—is higher, it will appear lower on a month-by-month basis.

Also, lenders will sometimes charge a higher interest rate for a short-term loan than for a long-term loan. But this doesn’t offset the duration effect of the term. Usually the total amount of interest charged for the loan will still be somewhat higher for the longer term loan despite the lower interest rate.

A borrower considering a loan should opt for the shortest term loan that is affordable, as long as the interest differential is not more than a couple of percentage points. This will minimise the total amount of interest charged, which can be a large cost for a loan. As well, the borrower should consider whether the repayments are affordable, and an affordability gap should always be allowed.
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