Why Personal Loan Repayment Timelines Are Important

If you’re looking to consolidate existing debt or cover a large purchase, a personal loan could be the best option. But before you take out any loan, you’ll need to understand the details to make sure doing so fits your budget.

When it comes to personal loans, the loan term is one key factor that could significantly impact your financial health. A loan's term is the duration over which you'll repay the borrowed amount. In the context of a personal loan, which has fixed monthly installments, terms generally range anywhere from one year to five years.

The terms of a personal loan also tie you to a repayment timeline. The amount you’ll owe each month will vary depending on the term length of the loan. Ultimately, no one loan term is the best. Choosing the right repayment timeline depends on your income, your savings, and how much flexibility you want.

How to decide on a loan repayment timeline

At first glance, a shorter term might always seem to be the preferred option when taking out a personal loan. After all, isn’t it better to be debt-free as quickly as possible?

But things aren’t that simple. While the accelerated repayment timeline resulting from a loan with a shorter term will result in you paying off the loan faster, a loan’s term can impact the amount you pay in a variety of ways. In certain instances, it’s better to take a loan with a longer term in order to achieve a more manageable repayment timeline.

Your loan term influences your repayment in three ways: it affects the interest rate you receive, the total interest paid, and your monthly payment.

How does the loan repayment term affect your interest rate?

When you apply for a personal loan, the lender will offer you an interest rate. As of the second quarter of 2023, rates on personal loans averaged about 11.5%, based on data from the Federal Reserve.

While the primary determinant of the interest rate will likely be your credit score and history, the loan term you choose will also have an impact. In general, lenders are more confident that shorter-term loans will be paid back than longer-term loans. That often results in lower interest rates for shorter-term loans.

How does the loan term affect your total interest paid?

Assuming both loans have the same interest rate, a longer-term loan will result in you paying more interest in total than a shorter-term loan. For instance, a $1,000 personal loan at 10% interest will cost about $55 in total interest charges for a one-year term but about $107 in total interest charges for a two-year term.

Now, that doesn’t necessarily mean that the two-year term is worse. Which one is the right fit depends on your financial situation. But since interest is the fee you pay to borrow money, it’s worth considering how you might be able to minimize that fee.

How does the loan term affect your monthly payment?

We already saw how your desired loan term can change the interest rate, which will affect your monthly payment. But your loan term will also affect the speed with which you have to repay the principal amount of your loan, which could have an even greater impact on your monthly payment.

Consider our previous example, of a  $1,000 loan with a 10% interest rate offered at either a one- or two-year term. For a two-year term, the monthly payment would be about $46, compared to about $88 for a one-year term.

Making a decision: The pros and cons

Here’s the bottom line: in general, the shortest loan term (and therefore the quickest repayment timeline) you can afford is probably going to be the best choice for you and your finances. But the key factor is making sure you can actually afford the monthly payment. Trying to make a smart choice by paying off your debt quickly can easily become a disaster if you start missing payments and default on the loan.

Let’s quickly walk through the pros and cons of choosing a shorter loan term.

Pros of a shorter-term loan

• Typically, lower interest rates than longer-term loan
• Get out of debt more quickly
• Results in lower total interest paid than longer-term loan (for equivalent interest rate)

Cons of a shorter-term loan

• Higher monthly payment
• Lack of credit building due to shorter payment history

Now, let’s say you’ve already taken out a personal loan, but you realize you can pay off the loan early and avoid all those subsequent interest charges. While it’s possible to pay off a personal loan early, it’s not always a smart idea.

Should you pay off a personal loan early?

When you take out a personal loan, you tie yourself to a planned series of fixed monthly payments. If your financial situation improves and you want to increase your flexibility, you might be tempted to pay off your loan early and clear your debt. This has the added bonus of potentially avoiding many months’ worth of future interest charges.

While this strategy can make sense in certain cases, you’ll need to be aware of potential downsides associated with early repayment.

What are early repayment penalty fees?

The biggest risk associated with paying off a personal loan early is penalty fees. While it’s possible to have early repayment of a personal loan with no penalty fees, most lenders are not so accommodating.

These fees can range anywhere from a fixed charge to a percentage of the remaining payments expected. When considering whether to pay down a loan early, you’ll need to ensure that you won’t end up paying more as a result of the penalties.

How does early repayment impact your credit score?

Additionally, paying off a personal loan early can often hurt your credit score.

Now, it might come as a surprise to hear that paying down debt early can be bad for your credit score – but it makes more sense when we consider the various factors that go into your score.

Your credit score is helped in part by having a good mix of loan sources. When you pay off a personal loan, you decrease the diversity of loans available to you, which could result in a drop in your credit score.

Moreover, paying off a personal loan early can lead to a shorter overall payment history on the loan. Since building up a reliable stream of payments is the biggest factor that affects your credit, you’ll miss out on the chance to improve your score.

It’s also important to note that since it’s an installment loan, a personal loan does not factor into your credit utilization. Therefore, paying it down won’t boost your credit score the way paying down a credit card does.

What are the benefits of early repayment?

Despite these drawbacks, early repayment can still be worth it. The main benefit of paying off a personal loan early is being able to avoid all the subsequent interest charges that you’ll owe over the life of the loan.

In addition, not having to pay a fixed amount each month can increase your flexibility substantially. Instead, these funds can be diverted towards your savings or to pay down other debt.

Finally, eliminating your personal loan debt can go a long way toward reducing your debt-to-income ratio. While this ratio is not a component of your credit score, it does play a significant role in determining your approval for other types of loans, most notably mortgages.

Ultimately, deciding to pay off a personal loan early hinges on weighing the costs and benefits based on your financial situation.

Personal loan repayment calculator

Looking for a personal loan repayment calculator to determine the monthly payment and total interest you can expect on a loan? Check out the personal loan calculator on Calculator.net.

Personal loan repayment schedule template

If you’re looking for an easy-to-use personal loan repayment schedule template, see this Excel file at Contextures.com. You can download the file at the end of the page. Using the template is simple – just plug in your loan details on the Payments tab, including the loan amount, total months, and annual interest rate.