Understanding Short Term and Long Term Loans
Loans are one of the most common financial tools that individuals and businesses use to finance various projects and investments. There are different kinds of loans available in the market, but two of the most common ones are short term loans and long term loans. The main difference between the two types of loans is their repayment period.
Short term loans typically have a repayment period of less than one year, while long term loans can have repayment periods that extend up to several decades. The repayment period is an essential factor to consider when choosing the type of loan you want to go for.
Short term loans are often used by individuals who need to cover unexpected expenses or require immediate financing. For instance, small businesses could take out short term loans to cover short-term cash flow problems or to purchase inventory. In contrast, long term loans are typically used by those who need to finance larger investments or projects that cannot be paid off in a single year. For instance, businesses could take out long term loans to buy real estate or finance costly equipment purchases.
One of the advantages of short term loans is that they typically come with lower interest rates. Since the repayment period is shorter, the lender faces less risk of not getting their money back. Similarly, the borrower can avoid paying more interest over time, which is a win-win situation. Furthermore, short term loans can be a helpful tool for improving credit scores since timely payments of these loans can reflect positively in your credit history.
On the other hand, short term loans can be more challenging to qualify for since the lender may view them as more risky compared to long term loans. Additionally, due to the shorter repayment period, the borrower may face a higher monthly payment, which could be financially straining.
In contrast, long term loans allow borrowers to finance larger investments and projects with a lower monthly payment, which makes them a convenient and popular option for many individuals and businesses. Additionally, they offer more flexible repayment plans, making it easier for borrowers to pay the loan off. However, these loans often come with higher interest rates, which means more money paid in interest over the life of the loan.
Pros of Short Term Loans
One of the main benefits of short term loans is their speed of access. When a borrower applies for a short term loan, the approval process can be quick and straightforward, with the lender often receiving the funds within the same day or within a few business days. This speed of approval makes short term loans ideal for those with immediate financial needs such as an emergency veterinary bill, an overdue car payment, or a health-related expense.
Another advantage of short term loans is the lower total interest paid over the life of the loan. Since the loan period is shorter than a long term loan, the interest paid overall will be lower, even if the interest rate on the loan is higher. Borrowers can save a substantial amount of money in interest over the life of the loan, making short term loans an attractive option to those looking to save money.
Furthermore, short term loans often offer lower interest rates than their long term counterparts. Due to the shorter repayment period, lenders take less risk, which translates to lower interest rates compared to long term loans. A lower interest rate means that borrowers can pay back a lesser amount than they would have with a long term loan, and this, in turn, keeps a borrower’s credit score intact.
Finally, short term loans can be a wise financial decision for those with a less-than-perfect credit score. Along with saving on interest payments, borrowers can use the short term loan as an opportunity to rebuild their credit rating by making regular and timely payments.
Cons of Short Term Loans
Higher Monthly Payments: Short term loans have shorter repayment periods, which translates to higher monthly payments compared to a long term loan with a similar loan amount and interest rate. The shorter repayment period can cause a financial strain on a borrower with a tight budget or a lower income.
Less Flexibility in Repayment: Unlike a long term loan, short term loans may offer less flexibility in repayment schedules, which can make it more difficult for borrowers to make payments on time. This inflexibility in repayment schedules might increase the risk of a borrower defaulting on their loan, which can cause financial problems in the future.
Rollover Fees: If a borrower is unable to repay their loan in full by the scheduled date, they might be required to roll it over, which extends the repayment period. While it can relieve some immediate financial burden, it often comes with additional fees such as rollover fees and additional interest charges.
Stricter Eligibility Criteria: Since short term loans are generally riskier than long term loans, lenders often have stricter eligibility criteria. Borrowers must have a more robust credit score, stable employment history, and a lower debt-to-income ratio. Those who don’t meet these eligibility criteria may not qualify for these loans or may end up with unfavorable loan terms such as higher interest rates.
High-Interest Rates: Although short term loans offer lower interest rates than long-term loans, they can still be relatively high compared to other types of loans. The higher interest rates reflect the increased risk that lenders take on with short term loans. Therefore, before applying for a short term loan, borrowers should assess whether they are getting a good rate and be sure to compare rates with long term loans.
Pros of Long Term Loans
Lower Monthly Payments: One of the significant benefits of a long term loan is that it comes with lower monthly payments compared to short term loans of the same amount and interest rate. Since the repayment period is longer, the payments can be extended over a more extended period, reducing the monthly payments’ financial burden.
Flexible Repayment Schedules: Financial institutions often provide flexible repayment plans to borrowers that can help them plan and manage their repayments effectively. Borrowers can choose between various repayment schedules, including monthly, quarterly, semi-annually, or annually, depending on what works best for them. Borrowers should understand the conditions of such flexible repayment plans, including potential prepayment penalties/fines.
Lower Interest Rates: Long term loans often have a lower interest rate compared to short term loans because a more extended repayment period reduces the risk for the lender. Moreover, interest rates for long term loans are typically fixed-rate, meaning the borrower is protected against any potential interest rate fluctuation. Lower interest rates mean borrowers save money on total interest payable, increasing their potential cash flow.
Borrowing Larger Amounts: Long term loans come in handy when borrowers plan to finance large investments such as buying a property, a car. These loans often permit borrowing more significant amounts, more than what short term loans provide, thereby enabling borrowers to fulfill their financial goals.
Increased Flexibility: Borrowers can use long term loans for a broad range of purposes, including buying a car, financing home improvement, expanding business operations, and more. The wide range of use means there is an increased sense of flexibility offered by a long term loan.
Cons of Long Term Loans
Long term loans offer significant advantages, such as lower monthly payments and more extended repayment periods. However, they also have some potential drawbacks that borrowers must be aware of before taking out such loans. Here are some of the cons of long term loans:
Higher Total Interest Payment: Although long term loans often offer lower interest rates, they result in a higher total interest payment because of the extended repayment period. Borrowers may end up paying significantly more in interest over the life of the loan, which can be costly, especially when financing a large investment.
Potential Prepayment Penalties: Many long term loan agreements include prepayment penalties that charge the borrower for paying off their loan before the end of the agreed duration. Such penalties negate the advantages of early repayment and add to the overall cost of the loan.
Longer Repayment Period: The longer repayment period, which is an advantage in terms of lower monthly payments, can also be a disadvantage because borrowers may not be able to predict their financial situation years in advance. Borrowers may also find it challenging to manage the repayment of such loans over a more extended period, especially if their financial condition deteriorates.
Higher Closing Cost: Long term loans may involve higher closing costs or origination fees, which are upfront fees paid to the lender for processing the loan. The longer repayment period means that the borrowers pay more origination fees or closing costs over the life of the loan.
Risk of Negative Equity: Negative equity is a condition that occurs when the value of the asset (such as property) securing the loan falls short of the balance due on the loan. Borrowers taking out long term loans, especially for property purchase, run the risk of negative equity if the property’s value depreciates significantly in the long run.
Choosing the Right Type of Loan for Your Needs
Consider your financial need: The first step in choosing the suitable loan type is to analyze your financial needs. Short term loans are best suited for individuals requiring quick access to money for immediate funding. Long term loans, on the other hand, cater to larger financial needs like buying a property or financing business expansion.
Evaluate the repayment period: Borrowers should evaluate the repayment duration of both types of loans by looking at their financial situation. Short term loans offer faster repayment periods, which can seem more manageable. Long term loans offer longer repayment periods and lower monthly payments, but borrowers must determine their ability to manage the loan repayment over that extended duration.
Compare interest rates: Although short term loans offer lower interest rates, it’s essential to compare the interest rates of both short term and long term loans carefully. Borrowers should also consider fixed vs. variable interest rates. Fixed interest rates offer stable payments, whereas variable interest rates can change based on market fluctuations.
Understand the eligibility requirements: Both short term and long term loans come with eligibility criteria that borrowers must meet. Short term loans have strict criteria, and borrowers must have a good credit history and employment status. Long term loans typically have more relaxed eligibility requirements than short term loans.
Analyze the total cost of the loan: Finally, borrowers should carefully evaluate the total cost of the loan, including the interest, fees, closing costs, among other costs. The total cost of a loan enables you to compare the cost of different loan offers.
In conclusion, borrowers must weigh the pros and cons of both short term and long term loans meticulously before deciding on the appropriate loan type based on their financial situation and borrowing needs. Factors such as repayment period, interest rates, eligibility requirements and total loan cost should all be considered before selecting the best fit for each individual or business.