What is a Loan term & loan costs?
What is the loan term exactly? This is the period between the payment of the agreed loan amount and the full repayment of the loan. The term is an essential part of any loan contract.
The duration of the term is mutually dependent on various factors. These factors are the amount of the loan, the agreed repayment rate, the amount of the agreed nominal interest and, last but not least, the agreed loan rate.
If one or more of these components change, this change affects the runtime. Conversely, the runtime can affect the other components.
The lower the repayment rate agreed, the longer the term, provided the other components remain unchanged.
The higher the monthly installments (and thus the repayment rate) agreed with otherwise unchanged loan terms, the shorter the term.
In practice, the credit term often plays a subordinate role in consumer loans, i.e. loans to private individuals.
Rather, the starting point is the credit installment that the borrower can afford to repay the desired loan amount or that he would like to make available monthly for the repayment of the loan.
Loan term as a cost factor
However, there are a close connection between the selected monthly installment, loan term and loan costs, which can be overlooked, which is shown in the following example.
A loan amount of 10,000 dollars is assumed, which carries an effective interest rate of 5%.
A short term means a high repayment rate. A high repayment leads to high monthly installments but low overall costs with the same interest rate.
A long term causes low monthly installments because the repayment is correspondingly lower. However, due to the low repayments, there are high overall costs.
Long-term loans look cheap because of the low monthly rates but are actually expensive. This effect is deepened by most banks’ interest rate policies. Many banks scale the interest rate according to the term. The sound limit is often 60 months. If the term is longer, the interest rates increase.
This observation is supported by Good Finance’s statistics on average interest rates. The next example is, therefore, closer to practice. An interest rate of 7% is applied for terms of over 60 months.
As the term increases, the total loan costs increase considerably, even with the interest rates remaining the same.
However, many banks charge higher interest rates for a term of over 60 months. This exacerbates the negative effect.
Loan term & purpose of financing
The borrower should also keep an eye on what he wants to finance with the loan. The loan term should in principle not be longer than the normal expected life or useful life of the object to be financed.
It is not very sensible to pay off something that can no longer be used. What is to be financed with the loan is very important for the loan term.
A car loan requires different loan terms than a home loan and different rules may apply to the rescheduling of an overdraft facility.
Acquisition loans are predominantly installment loans with a term of between 12 months and 96 months.
Sometimes there are loan periods of 120 months or even longer. Home loans granted as mortgage loans run regularly for 30 years.
Example: estimate the appropriate loan term
Before you take out a loan, some preliminary considerations are useful.
First of all, it is about financing needs. By this, we mean the acquisition costs of the project to be financed less than the available equity.
The next step is a budget bill. All expenses are compared to all income and converted to the month. Pre-credits should not be forgotten.
The amount exceeding the expenditure is the so-called freely disposable income. This monthly amount can be used to pay the loan installment.
Suppose you want to finance a car with a loan. The purchase price is 30,000 dollars. You can pay 5000 dollars. So you need a loan of 25,000 dollars.
Your freely disposable income should be 300 dollars. This amount is available to pay the monthly installment for the required loan.
Now think about the useful life of the vehicle and how long you actually want to use the vehicle.
Let’s say you want to use the vehicle, an Audi A4 Allroad A4 2.0 TDI, for about five to six years. This useful life is quite appropriate for cars.
They are expected to have traveled around 60,000 km after the planned service life. The value of the vehicle may still be around 18,000 dollars. You calculate with a safety discount that you cannot precisely assess the scope of use in advance.