The importance of the choice of the loan term: that is why it should not be underestimated

Those who take out a loan essentially have to deal with the question of the loan amount and the loan term. The answer to this question will determine the exact shape of the credit. But how do borrowers find the optimal loan term?

Briefly explained: What is the credit period?

The term loan term refers to the period of time over which the loan amount is repaid. 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. A 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. Therefore, the personal financial requirements and the loan amount are crucial for the question of the optimal loan term. The borrower, in coordination with the bank, determines the terms of the loan – which includes the loan term. To what extent the borrower has choices here is different depending on the individual 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 credit periods of several years or even decades. In general, a high loan amount – for example, in the course of a real estate purchase – is associated with long credit periods. Small loans – for example, to buy furniture – usually have short repayment terms.

Factors influencing the loan term:

• Amount of the monthly installments
• Credit amount
• Loan interest
• Type of loan

"Rules of thumb" for loan term:

There are some generally applicable rules for the loan term that serve as a guide for the decision:

Rule 1: The higher the loan amount and the lower the monthly repayment installment is to be, the longer the loan term must be.
Rule 2: The shorter the credit term, the lower the interest rate.

Rule 2 influences Rule 2: Those who choose a long credit period, 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 different options exist. Potential borrowers select a strategy based on which they determine the loan term:

Strategy 1: To keep the costs low, a short credit period is chosen.
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 credit term is of medium length.

No magic: The loan term and the monthly installments can be calculated with the help of formulas

Banks use appropriate software for the calculation of the loan term or the monthly installment amount. This software is based on mathematical formulas, which are briefly explained below. It is important to take the exact terms and conditions as a basis. In particular, it is necessary to define at what time the interest is calculated and at what times the installments are made. For example, installments can be made at the beginning of the month or the beginning of the year, respectively, or at the end of the month or the end of the year, respectively. The interest can be calculated monthly or annually. All these questions have an impact on the exact selection of the formula or have to be taken into account when applying the formulas. In order to present the calculation at this point as simply as possible by way of example, the following assumptions are made:

• Interest payment and redemption payment take place at the same time
• At the end of the year, interest is calculated in arrears
• The installment payment is made at the end of the year

Interest and amortization are two different payments

The term repayment installment describes the amount used to repay the loan, not the payment of interest. If the repayment rate is to remain constant, then the loan amount is divided by the loan term. A short repayment term results in high repayment rates:
Repayment rate = loan amount / loan term

What is the relationship between the annuity and the term of the loan??

Annuity is the annual payment amount of the loan. It is made up of the repayment installment and the interest payments. A long loan term results in 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 loan term?

The level of the interest rate determines the cost of the loan. The banks make an offer to their customers regarding the interest rate. Various factors influencing the interest rate exist:

• General interest rate trend
• Creditworthiness of the borrower
• Loan term
• Bank policy

The development of interest rates is based on the ECB's key interest rate. However, this statement does not mean that interest rates can be calculated in any way from the prime rate. Only "favorable times" and "unfavorable times" can be referred to. Interest rates can be generally at a high level or generally at a low level. The individual banks determine what interest rates they will issue. You may make individual (customer-dependent) decisions here. One influencing factor is the creditworthiness, another influencing factor is the credit period. Short credit periods represent a lower risk for 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.

Conclusion:

If you want to keep the interest costs low, you choose a short credit period. However, the monthly charge increases. It is important that the monthly installment can be reliably paid from the available budget throughout the loan term. The decision for the loan term – and thus for the installment amount – depends on the individual financial situation. Since each bank can determine the interest rate depending on the customer, it is necessary to obtain an individual offer from the bank if you wish to take out 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 of the principal is generally the largest item in the monthly installment payment.