Term Loans: What Are They?

You might think that all loans are created equal, but there are some key differences that can affect your finances. Let’s find out term loan meaning and what you need to know as a borrower.

A term loan is a loan that is repaid over a set period of time, which varies depending on the loan type, from one year for smaller loans to 30 or more for larger loans. A term loan generally accrues interest over its lifetime. You are likely already familiar with different loan types that use this structure, such as mortgage loans, auto loans, student loans, personal loans, and business loans. Typically terms last anywhere from three years for an auto loan to 30 years for a mortgage. You’ll always know how long your term is before signing any loan.

A term loan is one that has a defined payoff period, so you are consistently working to pay down the loan with each payment. That’s in contrast to revolving loans, such as credit cards, where the loan continues to grow as you add to it. A term loan consists of several parts:

Interest

When you consider a loan program, you’ll likely be offered a variety of different options, each with pros and cons. One of the most significant parts of the term loan is the interest you’ll be paying while you have the loan. It’s important to understand how that will accumulate over time.

There are three main types of interest you might encounter with a term loan:

• Floating: Sometimes called variable interest, this will go up and down in accordance with the market. That means your interest rate could go down, but it also could go up, raising your monthly payment.
• Fixed: This is a set interest rate that won’t fluctuate over the life of the loan, meaning which your payments will stay steady.
• Compound interest: This refers to how your interest will grow during the loan because each time interest accrues, you end up paying interest on that interest. An important factor here is the “compounding period,” which means how often this interest is calculated, from daily to annually.

Be sure to talk to your lender about these options and how they work together with other factors of the loan. For example, with a floating interest rate, you might pay a lower initial rate than you would with a fixed rate, but it also could rise over time and eventually become more than if you had paid the flat fixed rate the entire time.

Down Payment

The down payment is the initial payment you make to show the lender that you, too, have some “skin” in the game so to speak. Not all term loans will require a down payment, but they are commonly expected for auto loans and home loan down payments. The amount varies depending on the loan program you use, but a general rule of thumb is that the higher the down payment, the less you will pay over the loan term. That’s because the lender sees that you have already made a good faith effort to pay for part of the item and there is less risk involved for them so they may offer you better terms. And typically the more you put down up front, the smaller the amount accruing interest will be.

Down payment amounts vary; while a typical home loan down payment is 20%, there are many programs that offer much lower down payments. For a car loan, it’s common to put down 20% for a new car and 10% for a used car, but amounts can vary widely.

Repayment Plan

When you get the term loan, you’ll discuss a repayment plan. Here are two of the most common ways to pay a loan back:

Fixed payments: This means that you will have a schedule with your lender of how much you’ll pay back each month in a set amount. These are often referred to as installment loans.

Balloon payments: With balloon payments, you’re doing the opposite; you’re paying the lump sum at the end of the loan, which means that you might pay a low interest rate over the life of the loan, but then owe a large payment at the end. These are more rare than a fixed payment loan, but might work well for someone who wants to pay as little as possible now and believes they will have more income to cover the payment in the future.

Before you agree to a loan, make sure you understand if there are any prepayment penalties, which means that even if you wanted to make larger payments than you need to, the lender would charge you a fee. The reason is that they are counting on supplementing your loan with a hefty interest charge to make it worth their while, which you wouldn’t incur if you pay it off early.

You’ll also decide how long you want your loan to last; available time frames will vary between different types of loans.

Short-Term Loans

Short-term loans generally last one year to 18 months. The goal is to get a quick infusion of money when your cash flow is low, so they are often used for a business loan, such as to acquire inventory quickly, or a payday loan on a personal level.

Intermediate-Term Loans

An intermediate-term loan would run about one to three years. These could be car loans or student loans, and also might be business loans.

Long-Term Loans

The most common type of long-term loan is a mortgage, which usually lasts from 15 to 30 years. It’s best for a very, very high ticket item, like a house and possibly a college education in the form of student loans.

Small BusinessesSmall business loans help you keep your business running. The lender will usually want to know what you intend to use the money for, such as to finance a new location or expand your product line.MortgagesMortgages are typically taken out for 15 to 30 years. You’ll determine the type of loan you want, such as fixed or adjustable rate, which refers to the interest, and then how long the loan will last to arrive at your monthly payment. Auto loans have a similar setup to fixed rate mortgages where you will make a down payment, then finance the rest in a term loan with a pre-determined interest rate.Student LoansWhen you take out a student loan, whether through a private bank or with the government, you’ll be told upfront how much you can borrow and what the repayment terms will be. With some student loans, interest doesn’t accrue until you have graduated.

Are you considering a term loan? Here’s what you need to look for.

Watch Out For Long Repayment Periods

It might seem like a good idea to have a longer repayment period because that means you are paying less per month, which is appealing to your wallet. But the interest will continue to accrue, which means you will eventually pay more over the life the loan. In addition, the item you are paying for might decrease in value, especially a car, which means that you’re still paying on something that isn’t worth as much. Finally, there’s no avoiding the fact that paying off a loan can just feel good, while having a long repayment period means you just stretch it out while it hangs over your head.

Decide On Fixed Or Variable Interest

Since the interest can be a large component of the amount you end up paying, you want to make sure you aren’t paying more than is necessary. Since you likely can’t renegotiate a term loan, unless you pay it off and take out another loan, you want to make sure you understand the implications of the interest before you sign on the dotted line. Take into account the current interest rate and how long the term is, and calculate how much higher it would rise or fall if interest rates adjusted. There’s no right or wrong answer so be sure to do the math and choose the option that’s right for you.

Shop Around

As with any financial product, there are many options for term loans, and you want to make sure you’re getting the best deal for your personal financial situation. It could be you prefer a repayment plan that’s a bit shorter, which will mean you pay more each month yet avoid additional interest charges, or you may decide that managing your budget is the top priority at the moment, and you’ll need to pay a little less to ensure there is enough money to go around to cover all your bills.

Interest rates might vary among providers as well. They’ll take into account your credit score and how long you want the loan to be. Talk to several loan providers and find the one that works the best for you.

It’s quite likely that you’ll encounter a term loan in your financial life, whether you’re paying for college or buying a home or car. And you also might need a personal loan as a way to consolidate your bills into a loan with a set payback period that potentially has a lower interest rate than your existing bills. 

While most people eventually get a term loan, just make sure you’ve done adequate research to know how much you’ll be paying over the life of the loan so you can choose the one that’s best for your financial situation.

Find out more about term loans and other financial topics at Rocket HQ.