Choosing a loan term

Every loan term is a trade in one direction: a longer term lowers the monthly payment and raises what you pay in total. There is no term that is optimal in the abstract — only one that fits what you can actually pay each month without borrowing again. The arithmetic below makes the trade visible so you can choose it deliberately.

The arithmetic, with a worked example

Consider $12,000 at 11.5% over three terms. The payment falls as the term stretches, and the total interest rises sharply. The exact figures depend on the rate you are offered; the shape of the trade does not.

Use the loan payment calculator on this site with your own amount and rate. The pattern it will show you is that the last year of a long term costs far more than the first, because you are paying interest on a balance that a shorter term would already have cleared.

Source: Internal Revenue Service, standard mileage rates. Published in cents per mile.

What the IRS says mileage costs, as an example of a published rate

Not every number that affects a loan decision is a rate. If the thing you are financing is a vehicle you drive for work, the IRS standard mileage rate is the officially published figure for the cost of operating it, and it changes the affordability arithmetic.

The four questions that decide a term

**What payment can you make every month without fail?** Not the highest payment you could manage in a good month — the one you can manage in a bad one. A term you default on is more expensive than any interest rate.

**How long will the thing you are financing last?** Financing a car for seven years when it will be worth little after five leaves you paying for something you no longer have.

**Is there a prepayment penalty?** If not, a longer term with a commitment to pay more each month is strictly more flexible than a shorter term, because you keep the option to pay the minimum in a bad month.

**Is the rate fixed?** On a variable rate, a longer term increases the time you are exposed to rate rises.

• Never take a longer term to afford a bigger purchase than you planned.
• Check for prepayment penalties before choosing the flexibility argument.
• Ask whether extra payments go to principal and are applied immediately.
• Ask whether the lender re-amortises after an extra payment or only shortens the term.

How extra payments actually behave

An extra payment helps only if it is applied to principal, immediately, and without a penalty. Lenders differ. Some apply extras on the next scheduled date rather than the day received, which costs a month of interest; some apply them to future instalments rather than to principal, which does nothing except move the next due date; and some re-amortise so the term shortens, while others leave the term and lower the payment.

Ask three questions before you rely on overpaying: does the extra reduce principal on the day it is received, does it shorten the term, and is there a prepayment penalty or a minimum extra amount? Get the answers in writing, because this is a servicing behaviour rather than a contract term and it varies by lender.

The difference between term and amortisation

On a mortgage, the amortisation period and the term are different things: the amortisation is how long the schedule takes to clear the balance, and the term is how long the rate is fixed before you renegotiate. A longer amortisation lowers the payment and raises the total interest; a longer term delays the point at which your rate can change. Confusing the two in Canada, where five-year terms on twenty-five-year amortisations are standard, is how borrowers end up surprised at renewal.

On an instalment loan the two are the same thing, which is why the term is the whole decision there.

Matching the term to the life of the thing

The most useful discipline is to never finance something for longer than it will last. A car financed over eighty-four months will be worth less than the balance for years, which means a total loss accident leaves you paying for a vehicle you no longer have unless you have gap coverage — and gap coverage is itself a cost that a shorter term removes.

The same test applies to a roof, a furnace, a dental restoration and a renovation. Where the asset outlives the loan, a longer term is defensible. Where it does not, the loan is a bet that nothing goes wrong.

What to write down before signing

Record the amount borrowed, the amount you receive after any fee, the annual rate and whether it is fixed, the term in months, the monthly payment, the total you will repay, whether there is a prepayment penalty, and what happens if you pay late. If a lender will not put all eight in writing, that is the answer to a different question.

How to test a term before you commit

Take the amount you need and the rate you have been offered, and run the payment for the shortest term you could survive and the longest term on offer. Write down the monthly payment and the total interest for each. The difference in total interest is the price of the flexibility the longer term buys, and seeing it as a single number makes the choice much easier.

Then ask what happens if you lose income for three months. If the answer is that the longest term is the only one you could keep paying, choose it — and set up an automatic extra payment for the months when you can afford it, so the flexibility is a fallback rather than a permanent cost.

When a longer term is the right answer

When the alternative is not borrowing at all and the cost of not doing the work is higher — a failed roof, a car you need for work, a dental infection. When the rate is genuinely low relative to inflation. When the loan has no prepayment penalty and you intend to pay it faster than the schedule.

Where these figures come from

Related pages

• Personal loan costs
• Loan payment calculator
• Debt payoff calculator