Loan Term: Time Periods and Specific Features
Explanation of Loan Terms
A loan’s term can refer to several things. In most cases, the term is either:
- How long the loan will last if you 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? The time it takes to eliminate debt is a loan’s term. Loans may be short-term loans or long-term loans.
In some cases, the term is 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.
During a loan’s term, the loan must be paid off or refinanced.
When you get a loan (such as a 5-year auto loan), your lender typically sets a required monthly payment. That payment is calculated so that you pay off the loan gradually over 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 affects your monthly payment and your total interest costs (among other things). A longer term means you pay less each month, so it’s tempting to choose loans with the longest term available. For example, you might think a 72-month loan is more
attractive than a 60-month loan because it’s easier on your cash flow. But a longer term also results in higher interest charges over the life of that loan.
When you pay more interest, you effectively pay more for whatever you’re buying. The purchase price doesn’t change, but the amount you spend does.
Loan Periods: Loan periods are also related to time, but they aren’t the same as your term. Depending on the specifics of your loan, a period might be the shortest period of time between monthly payments or interest charge calculations. In many cases, that’s one month or one day. For example, you might have a loan with an annual rate of 12%, but the periodic (or monthly) rate is 1%.
A 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 your describes. When you borrow money, you and your lender agree to specific conditions—the "terms" of your
loan. The lender provides a sum of money, you repay according to an agreed upon schedule, and if something goes wrong, each of you has rights and responsibilities that the loan agreement provides details on.
Some of the most common terms in loan agreements appear below.
Interest Rate: This describes how much interest lenders charge on your loan balance every period. The higher the rate, the more expensive your loan is. It’s crucial to understand if your loan has a fixed interest rate or a variable rate that can change in the future.
Lenders usually quote rates as an annual percentage rate (APR), which can account
for additional costs besides interest costs.
Monthly Payment: Your monthly payment is often calculated based on the length of your loan and your interest rate. However, there are several ways to calculate the required payment. For
example, credit cards may calculate the amount as a small percentage of your outstanding balance. Make sure you know how much you need to pay each month—and if that amount can change. You need to verify that the current and future payments fit within your budget.
Prepayment Penalties: Minimizing interest costs is often wise. If you can pay off your debt faster than is required, you lose less to interest charges. 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 smart.
Balloon Payments: With some loans, you don’t pay down the balance gradually. Instead, you only pay interest costs or pay off a small portion of your loan balance during the loan’s term. In
those cases, you often need to make a large balloon payment (or refinance the loan with another large loan) at some point.
Prepare for a balloon payment by arranging financing (or earmarking liquid assets) several months or weeks before the payment is due.