What Is a Short-Term Loan?
7 Min Read
A short-term loan helps you to cover unexpected expenses, such as a medical emergency or car repairs. Because most short-term loans are unsecured, they don’t require you to put up collateral. This is the reason why lenders charge high-interest rates and fees to cover their risk. Also, these loans tend to have terms as short as two weeks in some cases, and the penalties for failing to repay on time can be steep.
However, these loans can be helpful if you can meet the repayment period on time, particularly for people who may not qualify for a personal loan because they have bad credit or no credit history. Read on to understand how short-term loans work, the different types of short-term loans, what to consider before taking out a short-term loan, and whether it is the right loan for you.
Short-Term Loan Definition
Short-term loan repayment periods tend to span no more than one month, and some terms are just two weeks. They are typically used by people who have an urgent need for financing, an unforeseen medical emergency, or they need to fix a broken AC system. The characteristics of a short-term loan are higher APRs because no collateral is required, and there are few requirements to qualify. Charging a high annual percentage rate (APR) is the lender’s way of covering the risk of lending without collateral.
How Do Short-Term Loans Work?
Banks, credit unions, or online lenders offer short-term loans with varying interest rates and terms. Most will charge an origination fee also. These loans have high-interest rates, up to 375% in some cases, and fees and penalties for late loan payments will apply. Short-term loans tend to be for lower amounts than long-term loans. That’s why you can borrow only up to $1,500.
Typically, a direct lender will do a soft credit check to check whether you can afford the automatic payments. A soft pull will not affect your credit standing, whereas too many loan applications with a hard pull can lower your standing. Most lenders require you to show ID, proof of employment, and a certain monthly salary and specify a bank account where the funds will be deposited. After submitting an application, loans are approved in as little as 24 hours, with money deposited the next business day.
Types of Short-Term Loans
Some short-term loans come with extortionate APRs, and many lenders are deceptive in their marketing. But you can choose the suitable financial product by knowing the types of short-term loans:
These loans are the riskiest type of loan. They are designed to see you through to the next paycheck. Loan amounts are typically $1,000 or less, and proof of income will usually suffice to qualify. The risk of default is high, so lenders charge exorbitant APRs and fees. Many borrowers cannot pay off their loan when it comes due in two or four weeks.
If you cannot pay the lender or the bank when the payment is due, you can usually roll over the loan for another two weeks. However, you will still owe the principal, additional fees, and interest, and your bank may also charge you an NSF (insufficient funds) fee. Many borrowers find themselves deeper in debt after using this type of loan. Because of this, these loans are considered predatory. According to the Consumer Federation of America, payday loan APRs can range from around 375 to 780 percent.
Car Title loans
To get auto title loans, so-called secured loans, you must use your vehicle as collateral. If you default, the lender assumes the ownership of your vehicle. You can typically borrow from 25% to 50% of the car’s value. Keep in mind that these loans also come with high APRs (around 300% percent), and repayment terms can be as short as 15 to 30 days. If you’re late with payments, the interest charges accumulate, and you may face late penalties also.
An overdraft from a bank or credit union is a way to cover temporary expenses. Banks offer overdraft facilities to members, meaning that money is transferred to your checking account as a loan to cover bills and expenses. However, the bank will charge a high APR on the balance until it is paid off.
Line of Credit (LOC)
A line of credit is a preset sum you can borrow to cover your expenses at any time until you have reached the limit. If it’s an open line, you can repay and borrow money again over a set period. Such loans are unsecured and carry a high APR.
According to the rating agency Experian, a LOC can impact your FICO score. if you use more than 30% of the borrowing limit, your credit score will drop. So pay attention to your credit limit and don’t exceed it.
There are three types of LOCs:
- Personal LOCs: You can borrow money for personal needs, but to qualify, you need a reliable income and a credit score of 670 or higher. Having savings, stocks, or certificates of deposit (CDs) can reduce the annual percentage rate.
- Home Equity LOCs (HELOC): To get such a loan, you must have a good credit score. The credit limit for a HELOC is typically 75% or 80% of the market value of the home, less the balance owed on the mortgage.
- Business LOCs: A business line of credit is useful for a business owner who needs money for operating expenses. The lender sets loan terms and the APR after considering the market value and profitability of the business.
When Does a Short-Term Loan Make Sense?
If you can avoid short-term financing, financial experts recommend doing so. A personal loan will give you much better terms and cost much less. However, these loans come with fixed payments and longer payback periods. A short-term loan makes sense if you need cash quickly and are sure you can pay off the loan within the set term. Remember that interest rates can reach 375% in some cases.
The benefits of short-term financing are that you can get money quickly and don’t need a high credit score. In fact, you can boost your score if you take out a short-term loan, make timely payments, and pay it off within the repayment period. However, such loans don’t help you increase your FICO ratings because they are not considered credit-builder loans.
The Benefits & Drawbacks of Short-Term Financing
- Easy loan application process;
- Funds deposited within 24 hours;
- No collateral in most cases;
- Low minimum credit score requirement.
- High APR and fees;
- High risk of default and burgeoning debt;
- Potential loss of assets if the collateral is used;
- Damage your FICO score if payments are late.
Things to Consider Before Borrowing Short-Term Loans
Before you take out a short-term loan, ask yourself the following questions.
- Have I researched the various loans along with the providers, their trustworthiness, and the fairness of their terms?
- Can I afford to pay back the loan amount with interest when the loan comes due and still cover expenses?
- Have I considered the alternatives to a short-term loan?
Alternatives to Short-Term Loans
There are better alternatives to short-term loans that come with less risk and cost less.
Borrowing from friends and family: This is the cheapest option, but if the loan repayment terms are not clearly laid out and adhered to, you risk creating a rift in family and friend relationships.
Personal loans: Personal loans vs. payday loans have better terms and rates depending on your FICO score. The downside is that borrowers must pay fixed monthly payments over a longer period, years usually. You can pay off a personal loan early, but you may be charged a prepayment penalty.
Salary advance: Your employer might offer you a salary advance so you don’t have to borrow money. With a salary advance, the employer advances your earnings, and the money is deducted from your future pay.
Credit card: Using a credit card might be a cheaper option than taking out a short-term loan. Compare the interest on the card to the interest and fees for a short-term loan.
Is a Short-Term Loan for You?
Short-term loans come with risks, and they should be a last resort. You’ll have to pay interest and late fees, and penalties if you can’t cover such a debt. You may also find yourself spiraling further into debt. However, short-term loans do have a place. If you need funds quickly and you can pay off the loan when it comes due, this type of loan could be just what you need when you face an unexpected financial emergency.
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