Your loan terms define when and how your financing will be repaid. Understanding how they impact your budget and overall costs can help you make better choices when taking out your next loan.
Learn how to read your loan terms so you can compare offerings between lenders and choose the best loan for your situation before signing any paperwork.
- Look at the APR in addition to the interest rate to understand the total cost of a loan.
- Longer loan terms lower your monthly payments but add to your total interest paid.
- Secured loans include collateral requirements in the terms, meaning you could lose the asset if you default.
- Always check for prepayment penalties before signing, as they can offset any savings from paying off your loan early.
Loan Terms Explained
When you take out a personal loan or other type of installment loan, the loan terms outline your repayment timeline and cost structure. Here are the main terms you’ll see defined in your loan agreement.
APR Vs. Interest Rate
When you apply for a loan, you’ll see quotes for both the interest rate and the annual percentage rate (APR). The interest rate is the flat percentage charged on your loan amount. But taking out a personal loan can come with other costs, like origination fees. The APR calculates the total cost of borrowing, including interest and one-time charges.
The goal is to help you compare the total cost of different loan offers. While one offer’s interest rate may be lower, the APR may be higher if it has excessive fees. APR helps give a clearer comparison of how much the loan will cost you overall.
Fixed Vs. Variable Rates
Another loan term that impacts the total cost is whether the interest rate is fixed or variable. With a fixed rate, the interest stays the same over the entire course of the loan. That means your monthly payment stays the same, making it easier to budget. Most personal loans, auto loans, student loans, home equity loans and have fixed rates.
A variable interest rate means that your rate can change alongside an index rate it’s tied to. Your rate is typically calculated as that index plus a fixed margin set by your lender. The loan terms will also outline how frequently your rate can change.
When your rate changes, your monthly payment amount does too. If rates increase, so will your payment; if rates fall, your payment also drops. There’s risk with a variable rate simply because you don’t know how much to budget each month. Variable rates are offered on adjustable-rate mortgages and home equity lines of credit (HELOCs). Credit card APRs are also variable.
Term Length
The term length is how long you’ll make payments before the loan is paid in full. Most personal loan terms range from 12 to 84 months. Opting for a shorter-term loan means that your monthly payments will be higher, since you’re paying off the principal over a shorter period. The benefit, however, is that you’ll be out of debt faster and pay less in interest overall.
A longer loan term usually results in smaller monthly payments because the balance is spread out over a longer timeframe. However, that extra time means more interest accrues, making the loan more expensive in the long run.
Monthly Payment
Your monthly payment is determined by the loan balance, interest rate and length of the loan term. As mentioned, a longer loan term means you’ll be in debt longer and will pay more interest over time, but your monthly payment will be lower.
Your lender uses your debt-to-income ratio (DTI), which is the percentage of your gross monthly income that goes toward your debts, to determine if you qualify for the loan and its corresponding monthly payments.
Fees
Some lenders charge fees, which are also included in your loan terms. A common one is the origination fee, usually 1% to 10% of your loan amount. Usually, you don’t pay that money out of pocket; instead, it’s subtracted from your loan distribution before you receive the funds.
For example, if you borrow $10,000 and have a 5% origination fee, it will cost $500. When you receive your loan funds, you’ll only get $9,500. It’s important to plan for that fee if it’s included in your loan terms, especially if you’re using the loan for a specific purpose.
Collateral
Some loans require collateral, which is usually a personal asset that guarantees the loan. If you default on payments, the lender can seize the collateral to sell and cover the outstanding balance. Secured loans require collateral, while unsecured loans do not. Although a secured loan may not seem as attractive, you may qualify for a lower interest rate since there’s less risk to the lender.
Prepayment Penalties
Another potential loan term is a prepayment penalty, which is a fee the lender may charge if you pay off your loan balance before it’s due. They may charge a flat fee, a portion of future interest or a percentage of the remaining balance.
Not all lenders charge a prepayment penalty, so check your loan agreement. When comparing offers, this could be a major deciding factor, especially if you hope to pay off your balance ahead of schedule.
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How To Compare Loan Offers
Loan terms affect your finances in two key ways: your monthly payment and your total cost. Because a low monthly payment doesn’t always mean a lower total cost, you need to evaluate the total interest and fees alongside your budget to find the best deal.
Use this framework to help evaluate which loan offer is right for you:
- Loan amount: You may receive different loan amount offers from different lenders. Even if you qualify for more, borrow only what you need.
- Monthly payment: Look at your proposed loan amount, interest rate, and term length to see if your monthly payment is affordable. Consider how variable rates may impact future payments.
- Upfront costs: Review the origination fees and any other charges that impact how much you actually get to borrow.
- Total loan costs: Add up total interest payments and upfront costs to calculate how much each loan will cost you overall. Weigh your options alongside the monthly payment to see which one is most attractive.
Larger loans, such as mortgage payments, come with substantially longer repayment terms to make them more affordable. Similar to auto loans, mortgages are secured by collateral, or the property you’re purchasing. Personal loans usually have lower loan limits and shorter repayment terms because they’re unsecured debt.
Example Of Loan Terms In Action
Let’s look at a hypothetical example to see how different loan terms impact your monthly payment and the overall cost of financing.
Say you borrow $20,000 with a personal loan and receive two quotes (minus any origination fees, which vary by lender).
Loan Quote A:
- Interest rate: 12%
- Loan term: 36 months
- Monthly payment: $664
- Total interest paid: $3,914
Loan Quote B:
- Interest rate: 15%
- Loan term: 60 months
- Monthly payment: $476
- Total interest paid: $8,548
As you can see, Loan Quote B has a lower monthly payment, but you’ll end up paying more than twice as much in interest.
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Common Borrower Mistakes
Make the most of your loan by avoiding these potentially costly missteps:
- Neglecting to check your credit report: Make sure your credit report is accurate so you qualify for the best loan terms possible. You can do so for free at AnnualCreditReport.com.
- Impacting your credit profile near the time of your application: Applying for many credit cards or other types of financing can signal to lenders that you’re facing financial hardship; excessive hard inquiries will also lower your credit score.
- Accepting the first loan offer you get: As you’ve seen, different lenders can structure your loan terms in different ways. Check multiple offers with different types of lenders – including banks, credit unions and online lenders – before choosing one.
- Borrowing more than you need: You don’t have to borrow the full amount you qualify for. Determine how much you’ll need, and borrow only that amount.
- Underestimating fees: Read your loan offer carefully to check for upfront fees and other financing charges beyond the interest rate.
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3 Tips To Optimize Your Loan Terms
Use this cheat sheet to try and qualify for the best loan terms possible:
- Boost your credit score: While improving your credit is generally a long process, you can achieve short-term wins by paying off debt to lower your credit utilization ratio (ideally, below 30% of your available credit) or requesting higher credit limits on existing credit cards.
- Check for loyalty rate discounts: Some banks and credit unions offer rate discounts if you have other accounts with them and enroll in autopay.
- Limit your rate-shopping window: Shop for loan quotes within a short period to have all those credit inquiries count as one. Newer credit scoring models allow up to 45 days, but lenders using older versions may limit the rate-shopping period to just 14 days.
FAQ
The Bottom Line: Use Loan Terms As A Decision Framework
Understanding your loan terms helps you determine the best offer for your needs. Whether you prioritize having a low monthly payment, maximizing interest savings or a combination of both, you need to know how each loan term impacts affordability and flexibility.
Knowing loan terms is the first step. The next is finding an offer that fits. Learn more and compare personal loan options.
Lauren Ward
Lauren Ward is a writer with over a decade of experience covering financial topics for businesses and publications. Her work has also been featured in major publications such as U.S. News and World Report, CNN, Business Insider, The New York Post and Bankrate. Her expertise includes real estate, mortgages, small business, insurance and more.
