Anyone who takes out a loan must essentially deal with the question of the loan amount and the loan term. The answer to this question determines the exact design of the loan. But how do borrowers find the optimal loan term?
Briefly explained: What is the credit period?
The term loan term refers to the period over which the repayment of the loan amount takes place. During this period the borrower makes regular payments to the bank. A long credit term leads to higher interest rates than a short credit term. This reason is an advantage of a short credit term. One disadvantage is the higher monthly burden: with a short loan term, there is less time available for repayment, which means that the installments are higher. Decisive for the question of the optimal loan term are therefore the personal financial conditions and the loan amount. The borrower determines the terms and conditions of the loan – including the loan term – in consultation with the bank. The extent to which the borrower has options here varies from case to case.
Different loans, different credit periods
Some loans are repaid over a relatively short period of a few months. Other loans, on the other hand, are based on multi-year or even decade-long credit periods. In general, a high loan amount – for example, in the course of a real estate purchase – is associated with long loan terms. Small loans – for example, for the purchase of furniture – usually have short repayment terms.
Factors influencing the loan term:
- Amount of the monthly installments
- Loan amount
- Loan interest
- Type of loan
"Rules of thumb" for the loan term:
There are some general rules for the loan term that serve as a guide for the decision:
Rule 1: The higher the loan amount is and the lower the monthly repayment rate should be, the longer the loan term must be.
Rule 2: The shorter the credit term is, the lower the interest rate is.
Rule 2 Influencing Factors Rule 2: Those who choose a long repayment term pay a higher interest rate. The monthly repayment rate (= amount used to pay off the loan, not the interest) is low, but the interest charge is higher.
Consequence: It is necessary to determine the monthly installment for the individually selected loan amount and the desired loan term depending on the interest rate. The underlying formulas take into account the amount of interest granted, which is credit-dependent.
How to find the best loan term?
Unfortunately, there is no general optimal loan term, but various options exist. Potential borrowers select a strategy based on which they determine the loan term:
Strategy 1: To keep the costs low, a short loan term is selected.
Strategy 2: To ensure that the monthly financial burden is as low as possible, a long loan term is selected.
Strategy 3: A compromise between low interest costs and low monthly installments is chosen: The loan term is of medium length.
No witchcraft: The loan term and the monthly installments can be calculated with the help of formulas
Banks use software to calculate the term of the loan and the monthly installments. This software is based on mathematical formulas, which are briefly explained below. It is important to take the exact framework conditions as a basis. In particular, it is necessary to define at which point in time the interest is calculated and at which points in time the installments are paid. For example, the installments can be made at the beginning of the month or year, or at the end of the month or year. The interest can be calculated monthly or annually. All these questions have an impact on the exact choice of the formula or have to be taken into account when applying the formulas. In order to present the calculation as simply as possible at this point as an example, the following assumptions are made:
- Interest payment and redemption payment take place at the same time
- At the end of the year, the interest is calculated in arrears
- The installment payment takes place at the end of the year
Interest and repayment installment are two different payments
The term amortization rate describes the amount used to repay the loan, not to pay the interest. If the repayment rate is to remain constant, the loan amount is divided by the loan term. A short loan term leads to high repayment rates:
Repayment rate = loan amount / loan term
What is the relationship between the annuity and the loan term??
Annuity is the annual payment amount of the loan. It is composed of the amortization rate and the interest payments. A long loan term leads to a smaller annuity than a short loan term. However, the loan amount and the interest rate also influence the annuity. The annuity is calculated using the following formula:
Residual debt = loan amount x (1 – t / years)
Interest amount = loan amount x (1 – (t – 1) / years) x interest rate
Annuity = repayment rate + interest amount = loan amount / years + loan amount x (1 – (t – 1) / years) x interest rate = (interest rate x (1 – (t – 1) / years) + 1 / years) x loan amount
with t as year.
What interest rate is applied to the loan depending on the term of the loan??
The amount of the interest rate determines the cost of the loan. The banks make their customers an offer regarding the interest rates. Various factors influencing the interest rate exist:
- General interest rate development
- Creditworthiness of the borrower
- Loan term
- Bank policy
Interest rates are oriented in their development as the key rate of the ECB. However, this statement does not mean that interest rates can be calculated in any way from the prime rate. It is only possible to speak of "favorable times" and "unfavorable times". Interest rates can be generally at a high level or generally at a low level. Individual banks determine what interest rates they will issue. They are allowed to make individual (customer-dependent) decisions in this respect. One influencing factor is the credit rating, another influencing factor is the credit term. Short credit periods represent a lower risk for the banks because the financial situation can be better assessed during the credit period and the credit is repaid more quickly. For these and other reasons, interest costs are generally lower for short loans.
If you want to keep the interest costs low, you choose a short credit period. However, the monthly burden increases. It is important that the monthly installment can be reliably paid from the available budget during the entire loan period. The decision for the loan term – and thus for the installment amount – depends on the individual financial situation. Since each bank can set the interest rate depending on the customer, it is necessary to obtain an individual offer from the bank if there is a desire for a loan, or to obtain information from the bank about the interest rates offered. The amount of the loan is an important factor in the decision, as the repayment installments are generally the largest item of the monthly installment payment.