Personal Loans: Short-Term vs Long-Term
- 18th July 2018
- Posted by: Loanable
- Category: Resources
When taking out a personal loan, as we can see, there are many various types of personal loans, for different purchases or financial needs.
The majority of personal loans are unsecured, meaning there is no collateral, or something physically securing the loan.
Personal loans can have variable interest rates, which is when the interest rates can change during the term of the loan, or they can be fixed interest rates. This is when the interest rate remains the same during the term of the loan.
The term of a personal loan can be broken down into two (2) categories:
Different lenders may use different terms or how long a loan is, when trying to fit the loan into one of these categories.
Some lenders may say loans of six (6) months or less are considered short-term. Other lenders may feel loans of 12 months or less are considered short-term loans.
Many will agree, loans over 12 months in payments, are more of a long-term loan.
So what does the term of a loan have to do personal loans anyway? It has plenty to do with the loan.
As a lender lending money, you get your money back quicker with a short-term loan, but you may not earn as much back in interest, as the loan is for a short period, you can only charge interest for that period.
A long-term loan of say 60 months or five (5) years, allows the lender to charge and receive interest over that five year period.
So while not a 100% “rule of thumb”, may short-term loans are going to carry higher interest rates than longer-term loans.
APR’s/Annual Percentage Rates and How They Work With Loan Terms
When you take out a loan, be it a payday loan, instalment loan, line of credit, all loans have one thing in common, interest. You are charged interest, or an interest rate, on the money you borrow.
This is one way banks and lenders make money, by charging interest on the money they lend out.
Interest rates vary among loans, and can be based on many factors:
* Type of loan
* The term of the loan
* The borrower’s credit score
If we know that a poor or low credit score means a higher interest rate, and a short-term loan can carry a higher interest rate, it would make sense that a borrower who has bad credit and a low credit score taking out a short-term loan would pay a very high interest rate on the loan.
If you make this assumption, you would be correct, and we’ll explain.
APR’s are annual percentage rates, and may appear different than what you are being told the interest rate is for a loan. APR’s take into account the interest charged, and any fees, and are then calculated over a 12 month period. This causes there to be a difference between the two figures.
APR’s take into account what you will pay for the loan over the course of a year.
So now let’s look at our previous assumption, bad credit, short-term loan are going to have high interest rates.
That is a correct assumption, and we will use payday loans as an example.
As personal loans go, payday loans are a very short-term loan, usually the loans are for 30 days or less; until the borrower’s next payday.
Payday loans are also aimed at borrowers with low credit scores, or bad credit. The loan does not take into account credit scoring as part of the underwriting or approval process.
As long as the borrower has:
* A job and wages
* A bank account
* Can afford to repay the loan
A payday loan can be granted.
However, when you combine the risk of a payday loan being a “bad credit loan”, with the short-term of the loan, you get a very high APR. In some instances the APR’s are expressed as 15005, 2000% or more.
The actual interest rates for the loans are still high, but when expressed in an annual form, they seem much higher. This is due to the fact payday loans are not meant to be a 12 month loan. They are for 30 days or so, and by expressing them in a 12 month format, the interest rates seem exceptionally high.
As we can see, the interest rates charged, and the term of a loan, has a huge affect on the cost of the loan to the borrower, but the term of a loan an also affect the monthly payments.
Term of a Loan and Monthly Payments
We know that the longer the term on a loan, the more interest a lender can earn, as they are collecting the interest for the loan over a longer period of time.
So again, short-term loans can carry higher interest rates, and long-term loans can carry lower interest rates. And one aspect of what affects the cost of the loan in the form on the monthly payment, is the interest charged.
If interest is collected on a monthly basis as a part of the monthly payment, a higher interest rate will cause the monthly payment to be higher.
It also goes to say that the longer the term of a loan, the more reduction in the monthly payments can be had.
A loan with a 24 month term, may have payments of £150 a month. If you were to take the same loan amount and interest rate, and extend the term of the loan to 30 or 36 months, or longer, you reduce the monthly payment.
This is important to realise and know with personal loans, and with all loans. By extending the term of the loan and reducing the monthly payments, it can help with affordability of the loan.