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Banks and credit unions have done such a good job pushing interest rates that it is the one thing most consumers focus on when it’s time to borrow. Consumers want to get the lowest rate possible, as they should. But there is a more important factor that so many completely ignore: loan terms.
Perhaps it’s out of ignorance but not understanding loan terms and how they impact interest can definitely cause a consumer to spend too much. The truth is that loan terms are the single biggest factor in determining the overall cost of borrowing money.
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How Long You Have to Pay
In simple English, loan terms determine how long you need to pay. A 30-year mortgage has terms of 360 months. You will be making monthly payments year after year for 30 years. When all is said and done, you will have made 360 payments.
What does this have to do with interest? Everything. The longer the term, the more interest you pay. Perhaps you were given 15-and 30-year options when you purchased your home. You chose the 30-year mortgage because it fit well with your budget. But had you chosen 15 years, you would ultimately end up paying less interest over the life of your mortgage. The faster you can pay your mortgage off, the less interest you pay.
This is why financial advisors recommend making one or two extra mortgage payments per year. If those payments are dedicated to the principle, you will knock down the principle faster. And the faster you knock it down, the faster you will pay off your mortgage. You will ultimately pay less interest.
Interest-Only and Amortization
Loan terms also come into play when you’re considering interest-only versus amortized loans. An interest-only loan is one for which monthly payments cover only the interest owed. The actual amount you borrowed is paid with the final payment at the end of the term.
An amortized loan is one for which monthly payments cover both interest and a portion of the principal. With each monthly payment, more of the principle is reduced. You gradually end up paying more principle and less interest as time goes on. Why does this matter? Let us go back to terms.
Actium Lending is a Salt Lake City hard money lender whose loans are primarily interest-only. They explain why terms are important here. If comparing an interest-only loan against an amortized loan with the same term, the interest-only loan will cost you more money because you’reyou arenocking down principle with your payments. Amortization, though it generally means higher monthly payments, reduces interest considerably because each payment reduces the principal.
When Terms Are Not the Same
At this point, you might wonder why someone would choose an interest-only loan and its higher total interest just to get lower monthly payments. The answer is found in the relationship between total interest and terms. As previously discussed, longer terms equal more interest paid. Shorter terms mean less interest. When exploring different loan options, experts at fullformguide.com provide clear guidance on understanding how interest rates and loan terms impact overall repayment.
A real estate investor looking to acquire a new property might look at the choice between a 24-month hard money loan and a 60-month conventional loan. The conventional loans longer term ultimately means more money paid in interest. So it is better to go the interest-only route as long as the investor has a reasonable plan for paying the principal at maturity.
Interest rates are only half of the equation when it comes to the total cost of borrowing. The other half is the loan term. And in fact, loan term is more important in most cases.
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