Term

Term
The term of a loan is the pre-determined amount of time before the loan must be paid back in full, plus interest. Term can also refer to the conditions under which a loan is made, which include the interest rate, monthly payment amount, and associated fees or penalties.

What is a loan Term?

A loan term is the pre-determined amount of time before it must be paid back to the lender in full, as well as any accumulated interest.[1] Additionally, the word “term” can refer to the conditions of the loan, such as the interest rate, the monthly payment amount, and the associated fees and penalties, and more. These details are usually referred to as the loan’s “Terms and Conditions”

What kind of loan Terms are there?

The term of a loan should always be agreed upon prior to the signing of a loan agreement. Loans typically fall into two categories: short-term loans and long-term loans.

Short-term loans are generally considered to be any loan that is 12 months or shorter. Some short-term loans are structured to be as brief as one week. Payday, title and pawnshop loans are three very common types of short-term loans. Payday loans have an average term of 14 days,[2] while title loans and pawn shop loans have an average term of a month.[3] These short-term loans can also have extremely high Annual Percentage Rates (APRs), oftentimes 300 percent or higher.

Long-term loans are generally considered to be any loan that is 12 months or longer. A standard, unsecured personal loan will have usually have a term of 36 to 60 months (that’s three to five years). A standard auto loan will typically have a longer term of 60 to 84 months (five to seven years). Home mortgages usually come with either a 15-year or a 30-year term.

How does the term affect my loan?

The length of a loan’s term has a very sizeable effect on the loan’s repayment structure. In general, the longer the term, the lower the payments. Of course, this doesn’t mean the borrower will be paying less money overall. In fact, it’s usually the opposite: loans with longer terms can actually be more expensive.[4]

How does the Term affect long-term loans?

Long-term loans are almost always installment loans. This means that the loan is paid back in a series of regular, amortized payments. (Amortization refers to a payment structure that is fixed, regular, and goes towards both the principal amount loaned and the interest.) Most installment loans are paid back on a monthly basis.

Since an installment loan is going to be paid back in equal installments, a loan with longer terms is going to mean a greater number of payments. And the more payments there are, the smaller each payment is going to be. Each payment has to cover a smaller percentage of the principal amount owed.

However, even though the individual payments will be smaller, the borrower will end up paying more on the loan overall. Because the loan is outstanding for a longer period of time, it will also be accruing interest for a longer period. This is why a loan with a longer term is more expensive than an equivalent loan with a shorter term.

Some long-term loans are interest-only loans, that means that the borrower only owes payments on the interest over the life of the loan. However, full repayment will still be due at the end of the loan’s term. Any larger payment owed towards the end of a loan is known as a “balloon payment.” Some mortgages are structured this way. With loans like these, the goal is almost always to refinance the loan by the time the balloon payment is due. These loans are generally for experienced investors only.

How does the Term affect short-term loans?

Some short-term loans are installment loans, which means that the term affects them in much the same way that it affects long-term installment loans. However, the majority of short-term loans are not structured as installment loans. They are structured with only a single, lump sum payment due at the end of term.

Due to this structure, many borrowers have trouble repaying these loans when they are due. For the most part, the borrower is then given the option of rolling over the loan, which means that they pay only the interest owed on the loan and, in return, receive an extended term with additional interest.

While the majority of long-term loans have their interest rates expressed as a yearly rate, short-term loans oftentimes do not. For instance, a 14-day payday loan would be described as having an interest rate of $15 per $100 borrowed. That rate only applies for the original, 14-day term. If the borrower rolls over the loan, they would then owe an additional $15 per $100 on the new term. This would make the effective interest rate for the loan $30 per $100 borrowed.

This is why the APRs for short-term loans are often 300 percent or higher. For instance, a 14-day payday loan with an interest rate of $15 per $100 borrowed would have an APR of 390 percent. Similarly, the average title loan has a monthly interest rate of 25 percent—which adds up to an APR of 300 percent.

These loans are not amortizing, which means that payments made on the loan do not necessarily go towards the principal. In fact, rolling over the loan oftentimes requires nothing more than paying down the interest. It is easy for borrowers who cannot afford full repayment on their loan to simply keep rolling the loan over, as this option is far more affordable. However, since they are only paying down the interest, they are not actually getting any closer to paying off the loan itself.

Short-term loans with this kind of structure are often referred to as “predatory loans.”  Borrowers who are only able to afford the interest payments on their loans are said to be “stuck in a cycle of debt.” The loans are considered predatory because their structure easily lends itself to borrowers becoming trapped in a debt cycle.

How does the Term affect lines of credit?

A line of credit is different from a regular loan. Rather than receiving money in a single lump sum, the borrower is instead given a maximum credit limit that they can borrow up to. The borrower only owes interest and repayment on the funds they actually withdraw, not the full credit limit. The term for a line of credit depends on the specific agreement that the borrower has with the lender. However, many of them have a more flexible payment schedule than you would find on your typical installment loan.[5]

With a revolving line of credit, the available funds replenish as the balance is paid down. This means that the borrower can ultimately borrow far more than their credit limit, so long as they make their payments. Credit cards operate as revolving credit lines.

With credit cards, there is often a monthly minimum payment due. The minimum amount is very small compared to the standard monthly payment for an installment loan. Since these minimum payments are so small, it could take a borrower many years to pay off their credit card paying only the minimum payments. This also means owing a far greater amount in interest. This is why people are always advised to pay more than the monthly minimum on their credit card.

References

  1. “Term.” Investopedia.com Accessed Aug 2, 2016. https://www.investopedia.com/terms/t/term.asp
  2. “Payday Loans and Deposit Advance Products.” ConsumerFinance.gov. Accessed Aug 2, 2016. https://files.consumerfinance.gov/f/201304_cfpb_payday-dap-whitepaper.pdf
  3. Montezemolo, S. “Car-Title Lending.” ResponsibleLending.org. Accessed Aug 2, 2016. https://www.responsiblelending.org/state-of-lending/reports/7-Car-Title-Loans.pdf
  4. Pritchard, J. “Loan Term.” Banking.com. Accessed Aug 2, 2016. https://banking.about.com/od/loans/a/Loan-Term.htm.
  5. “The Basics of Lines of Credit.” Investopedia.com. Accessed Aug 2, 2016. https://www.forbes.com/sites/investopedia/2013/08/06/the-basics-of-lines-of-credit/2/#d8073b02e38d