Lack the cash to make an extra-large purchase? Want to consolidate your high-interest credit card debt? Planning a wedding and need to come up with deposits a year in advance? Personal loans can be a good solution. But you should match your personal loan terms to your needs and resources.
How Personal Loan Terms Work
Personal loan terms refer to the amount of time you get to repay them. Most personal loans have fixed interest rates. They are installment loans, which means you repay the loan in monthly installments over a pre-determined number of months. Usually, the payments are equal because the interest rate does not change. There are no surprises - you make your fixed monthly payment for the required number of years and your balance hits zero at the end of the term.
Long-term Personal Loans or Short-term Personal Loans?
The good news is that lenders offer many personal loan terms to meet individual needs. You can pursue a short-term personal loan and pay it off in a few months. You can opt for a long-term personal loan and repay it in 12 years. Or choose a length in between.
When choosing a term for your personal loan, you'll consider:
- The purpose of the loan - most personal finance experts caution against using long-term financing, like a 10-year loan, to finance a short-term item like a vacation or wedding
- Your resources - the longer the term, the lower your monthly payment. If you absolutely need to pay for something and have to keep the payment as low as possible, a long-term personal loan might be your best option
- The interest rate - short-term personal loans usually come with lower interest rates
- Flexibility - If you take a long-term personal loan, your required payment is lower. But you can usually make higher payments when you can afford them or pay the whole thing off early. And when money is tight, you can fall back on the lower required payment. This can be very useful for self-employed borrowers or those who earn commissions
Match Your Personal Loan Term to Your Needs
"Most personal loans tend to fall into a range from about 36 months at the shorter end to 60 months at the longer end," says Chris Dervan, Senior Vice President of Personal Lending for PNC Bank. "Longer-term loans may be more difficult to qualify for or have additional restrictions with some lenders."
That said, you need to consider the payment you can afford - one benefit of longer terms is a lower payment - and the purpose of the loan.
If you're financing college tuition or a value-adding home upgrade, a ten year personal loan may make a lot of sense. Especially if you lack home equity to borrow against or don't want to put your house on the line. But do you really want to still be paying off your honeymoon cruise on your tenth anniversary?
Personal Loan Terms and Interest Rates
Dervan adds that shorter-term loans may qualify for a lower interest rate. But they may also have a higher payment for a given loan amount and interest rate compared to a longer-term loan.
However, the interest rate will vary depending on the amount you're looking to borrow, the term, and your credit rating.
"For example, say your personal loan has a principal amount of $5,000 for a 36-month term," says Anuj Nayar, Financial Health Officer for LendingClub. "You may qualify for an interest rate of 6.03%. If so, you would be scheduled to make 36 monthly payments of $152.18."
But assume you needed a longer-term personal loan.
"Say your principal amount was $15,000 spread out over 60 months. You may qualify for an interest rate of 7.90%. In this case, you would be scheduled to make 60 monthly payments of $303.43."
Realtor and attorney Bruce Ailion says those interest rates are pretty good if you're eligible.
"They beat the revolving rates on credit cards - which can range from 9.9% to 36%," says Ailion. "A personal loan is likely going to be in the range of 6% to 18% in today's market - depending on your credit."
Personal Loans for Debt Consolidation
Paying off credit card debt is the most popular purpose of borrowing with a personal loan. "Americans today owe a record $1.04 trillion in credit card debt. That's up from $854 billion five years ago," says Nayar.
"A personal loan also provides you with a fixed interest rate and a clear repayment end date. And it could increase your credit score by more than 20 points. That can help you secure other forms of healthy credit in the future."
The advantages that personal loans have over credit cards are these:
- Most personal loans have fixed interest rates
- Personal loan interest rates run about 7% lower than those of comparable credit cards
- You can't get tricked into decades of debt with ultra-low minimum payments that do little to reduce your balance
- Your debt has a finite end. Installment loans, unlike revolving credit cards, have definite payoff dates
- Fixed monthly payments make personal loans easier to budget
Debt consolidation with a personal loan can work very well - for the right borrower.
Personal Loan Terms for Debt Consolidation
When considering a personal loan for debt consolidation, check these factors:
- How much do you owe, and what interest rate can you obtain?
- Are you disciplined enough to stop using your credit cards once the balance is zeroed? Because 85% of consumers who consolidate debt fail
- Would you get better terms with a non-profit credit counselor and debt management plan (DMP), assuming that you qualify for assistance?
- Can you clear your debts with a personal loan in five years or fewer? If not, and you have debt problems, no savings and little chance of increasing your income, debt consolidation may not be your best option.
A major reason that many fail in their debt consolidation effort is that they can't afford the payment - whether it's a personal loan or DMP. The other major reason is that they continue to overspend. So if you take out a personal loan to pay off credit cards, be very confident that you can leave your credit cards alone. Don't carry balances. Don't spend more than you earn.
Personal Loan Terms and Interest Cost
Many underestimate the effect of extending their personal loan term on the total cost they pay. Smart borrowers choose the shortest possible term and highest payment they can reasonably afford. Here are the payments and total interest costs of an 8% $10,000 loan over a three, five and ten year period:
- $313 payment, total interest: $1,281
- $203 payment, total interest: $2,166
- $121 payment, total interest: $4,559
So you can see that coming up with a little more now can save you a lot later. Of course, the beauty of personal loans is that you can borrow what you need and tailor the term and payment to your ability to repay.