Disadvantages of Long-Term Financing

A mortgage is a common example of long-term financing.

Borrowing money to finance a purchase includes factors for repayment that can shape your financial future. Choosing long-term financing means setting up installment payments that are lower than those for a shorter repayment plan. The benefits of lower payments come with some disadvantages as well. Weigh the relative merits of the terms available to you and decide if long-term financing makes the most sense.


Higher Interest Rates

The interest rates available for a long-term financing agreement are usually higher than the rates available for shorter-termed loans. Generally, the level of the interest rate is established based upon the risk involved with making the loan. Long-term financing includes a greater span of time for default. A shorter term is less risky to the lender, as it is easier to forecast a borrowers financial status in the short term than it is to be sure the borrower will have the means to satisfy the loan payments decades down the road.


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Greater Interest Cost

The higher rates alone for a long-term loan mean that you will pay more over the life of the loan than you would for a short-term loan, and that is exacerbated by the length of time you'll be paying the higher interest rates. A shorter loan has less time for the interest to accrue. For example, a loan for $50,000 at a rate of 4 percent annually over 10 years will include paying $10,747.60 in interest. The same loan amount, even at the same interest rate, when paid over 20 years will include $22,717.60 in interest payments.


Debt-to-Income Ratio

Accessing credit involves a review of your total financial picture. Included in that picture is your debt-to-income ratio, or the amount of outstanding debt you owe in relation to the amount you earn. The longer the terms for your loan, the longer you will have a hefty number in the "debt" column of your credit worthiness evaluation. Choose a shorter term loan to pay it faster and lower your debt.


Slow Growth of Equity

Long-term financing, such as a home mortgage, accrues equity as you repay the loan. Equity is important in determining how much you have versus how much you owe. Your net worth is defined as your assets minus your debt. Long-term financing, with generally smaller installment payments, adds equity at a slower rate than would shorter repayment terms. The sooner you pay down the loan, adding equity to a business or home, the more your net worth is increased. Equity is also valuable, if not necessary, when seeking a loan or line of credit using your home as collateral. Often, the amount of equity you have in your home will determine whether your loan or line of credit application is approved or denied.



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