When you take out a loan to buy a car, a house or pay for school, you'll probably agree to an installment loan. In this type of loan, you'll pay down the balance in equal payments over a predetermined period of time. Lenders typically offer installment loans over three to 15 years, depending on the size of the loan. Longer loans have advantages and disadvantages, depending on the type of loan and your financial situation.
Splitting up the loan balance over a larger period of time results in lower monthly payments. For example, if you want to pay back a $10,000 loan with 5 percent interest over three years, your monthly payment will be $299.71. If you pay back the same loan over five years, your monthly payment will be $188.71. A longer loan can make your monthly payments more manageable and is easier on your monthly budget.
Larger Loan Amounts
Taking out a longer loan allows you to borrow more than compared to a short-term loan. Say you're in the market for your first car and have a monthly payment budget of $300. If you opt for a three-year loan with 5 percent interest, you'll be able to borrow $10,000. If you're willing to take out a five-year loan, you can borrow up to $16,000. With a longer loan you can purchase a more expensive option you couldn't otherwise afford -- if you don't overextend yourself.
Interest rates are usually higher on long-term loans because there's a higher chance of default. However, the higher interest rates on long-term loans are often mitigated by tax benefits. The U.S. government has historically offered a tax break on interest payments toward student loans and first home mortgages. Keep abreast of tax code changes or talk to a tax accountant to see if you qualify for any loan-related deductions.
Many individuals opt for short-term loans because they'll pay less over the lifetime of the loan. Although you might pay more overall with a long-term loan, it can be helpful to have the extra cash you'll save from making lower payments. Consider reducing your payment budget and putting the excess cash in a rainy-day fund for emergencies or other necessary expenses.
- Kiplinger: Why a Long-Term, Fixed-Rate Home Loan Makes Sense
- Do You Have to Be Crazy to Take on a 96-Month Auto Loan?
- Economics Today and Tomorrow. McGraw-Hill, 2002.
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