What you need to know about short term loans

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Short-term loans can be tempting if you need cash quickly. You apply for a loan, get the funds you need and pay them back in a short amount of time. These loans can be a lifesaver when you’re trying to scrounge together emergency funds for car repairs or medical bills without getting a loan from a bank.

However, short-term loans are fraught with risks, including high fees and interest rates, brief repayment periods, potentially unscrupulous lenders. These types of loans should be approached with great caution.

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What are short-term loans?

Short-term loans are loans given with little to no collateral that are to be repaid in a year or less, sometimes weeks or months. Most require proof of employment with a certain monthly salary, a bank account and a driver’s license or another form of ID. Because there is often no collateral and the credit requirements are lower, these loans charge a higher interest rate (up to 400 percent) and may have other fees and penalties.

How do they work?

Many of these loans can be applied for and received quickly, and there are many providers to choose from. You simply submit your application (usually online) and proof of employment or other credit information. Then the company reviews it and gives you an offer of the terms of the loan including the amount, interest rates, fees and repayment schedule. If you agree, you sign the contract and get your money, often in as little as 24 hours.

Most short-term loans are offered for less than $2,000 with repayment due in a matter of weeks.

Types of short-term loans

Short-term loans come in several types, each with different characteristics, fee structures and terms:

  • Payday loans: One of the most common is the payday loan, which provides cash for borrowers as they await their next paycheck. Usually, the only requirement is a pay stub to prove you have a job. These loans often require prompt payback — as soon as your next paycheck clears — and many come with enormous APRs and fees.
  • Car title loans: Another type of short-term lending, a car title loan, allows the borrower to use their vehicle as collateral as long as it’s owned outright. These loans usually only pay out a fraction of the car’s market value (usually up to half its worth) and can come with APRs of 300 percent and repayment windows as short as 30 days.
  • Bank overdrafts: Bank overdrafts, where customers get temporary coverage from their bank at a hefty interest rate when their accounts lack the necessary funds, are also a form of short-term loan. As are installment loans, where borrowers have regular, frequent payments over a period of time until the principal and interest have been repaid.

Other options include lines of credit, which are extended by banks or credit unions to bridge temporary cash flow challenges, and bridge loans, which can be useful during real estate transactions when a new house has been purchased while the other property is still on the market.

Why you should avoid short-term loans

Short-term loans should be used only as a last resort to cover expenses that must be paid where you have no other alternatives.

Interest rates and fees

The interest rates on these loans are often very high. For just a few thousand dollars (most lenders won’t offer much more than $10,000 or $15,000 at most), the borrower could be on the hook for an APR approaching 400 percent or more.

Lenders expect their money to be paid back quickly—certainly within a year, usually in just a month or two weeks. You need to make sure you have a solid plan to pay it back within the terms of the loan because the consequences can cost you even more. If you are unable to repay the principal within the allotted terms, sizable late fees begin to accrue.

Credit score penalties

These loans may also affect your credit score, both positively and negatively. Some companies make what is called a hard inquiry on your credit, and your credit will take a slight hit for that. Additionally, if you miss a payment or don’t pay off the loan in time, your credit will also be negatively affected.

Potentially hazardous cycle

The biggest drawback to short-term loans is that often they do not adequately solve the underlying problems that cause you to need a short-term loan. In fact, with their high interest rates and fees, they often make the problem worse.

You have to pay the interest and fees to get the short-term loan, so you have less money next month, which makes it even more likely you’ll need another loan. It’s a vicious cycle that’s difficult to escape.

Alternatives to short-term loans

There are short-term loan alternatives that may work for you. While these alternatives may not work for everyone, you might consider one or more of the following:

  • Asking friends and family: If you do borrow money from friends and family, make sure that both of you are clear on if and how the money should be repaid — otherwise the loan can damage your relationship.
  • Borrowing from the equity in your home: If you have a larger emergency or one that is not urgent, and own your home, you may be able to tap into your home’s equity with a home equity loan or line of credit. These alternatives usually take a few weeks.
  • Taking out a personal loan: Personal loans can be an alternative to short-term loans as well. The terms and rates that you get with a personal loan vary depending on your credit, but they’re usually much better than those of most short-term loans. Personal loans typically have a fixed repayment period over the course of a couple of years.
  • Using a credit card: If your emergency can be paid with a credit card, it may be a better and cheaper option than taking out a short-term loan.

The bottom line

Although short-term loans are convenient and seem like a great way to fix a temporary problem, they come with a lot of risks. The fees and interest rates can top 400 percent and payback terms can be as little as two weeks. Missing payments will negatively affect your credit score and cost you more in late fees, penalties and interest. This can lead to a cycle of borrowing that is difficult to break out of. Research all your options before you apply for this type of loan.