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When you take out a personal loan, chances are good you're going to have a choice as far as your repayment time. Depending on your lender, you may be able to decide to repay your loan in as little as a year or two, or you may be able to opt for a repayment schedule that stretches out over 10 years or more.
This decision may not seem like it's that important, but the reality is that your timeline for paying back your debt can profoundly affect your finances. Here's why.
Your payoff timeline determines monthly payments and total costs
The simple reason why your payoff timeline is so important is because the time you take to pay off your loan affects:
- The amount of your monthly payment.
- The total amount you'll pay in interest over time to borrow.
There's actually an inverse relationship between these two factors, so there's a key tradeoff you'll have to consider when borrowing.
If you choose a shorter repayment time, every monthly payment you make is going to be higher. This gives you less flexibility in your monthly budget because you'll be devoting more money to getting your loan paid off sooner. But because you will pay interest for a shorter period of time, your financing charges -- and thus total borrowing costs -- are lower.
The reverse is true if you opt for a personal loan you'll take longer to pay off. With more time spent paying interest, your loan will cost you more in the long run. You'll usually also have to pay a slightly higher interest rate for a loan with a longer payoff time rather than a shorter one, so this only adds to the extra costs you'll incur.
Of course, your monthly payments will be lower when you're taking more time to pay off your debt, so that means you may be able to accomplish more things with your money during the time you have the loan rather than sending larger payments to creditors.
To understand just how big of an impact your payment timeline can have, consider a $10,000 loan. If you opt for a two year repayment timeline and your interest rate is 7%, you'd pay around $746 in interest over the life of the loan, but each monthly payment would be $448 -- a pretty hefty sum.
If you took the same $10,000 loan to be paid off over five years, though, and your interest rate was 8% instead, then you'd pay $2,165.84 in interest but each monthly payment would be a much more affordable $203.
Should you choose a longer or shorter loan payoff time?
As you can see, you'd save a lot of money by opting for the shortest loan payoff timeline possible. But you also need to consider the fact you'll be tying up a lot more money each month.
In most cases, it's better to choose the shorter payoff time and the cheapest loan, though, as the rate on personal loans can be close to -- or higher than -- the ROI you could earn with a safe investment. In other words, you'll probably end up better off by repaying your loan early rather than making smaller payments and investing the difference. You also can't deduct interest on personal loans from your taxes in most cases, so there's no real benefit to paying interest for longer.
Ultimately, though, you want to make sure your monthly payments are affordable. If there's a chance you won't be able to comfortably cover payments with a shorter-term loan, then you may not want to take that risk. So consider your financial situation, your goals, and your budget and make the choice that's best for you.
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