Possible Risks of Short-Term Personal Loans
Trevor Mahoney is a financial services writer and content creator based out of Los Angeles, California. He holds a Bachelors of Science in Finance from Santa Clara University. In his free time, he enjoys hiking and lounging on the beach.
At a Glance
Short term personal loans are specialty loan types that have a quick application and decision process. In most cases, they require very little collateral, if any, which makes them an appealing option to borrowers. However, there are several risks to this type of loan that may make it the wrong option for your financial situation.
In this article, you’ll learn:
What are short-term personal loans?
Diving a little deeper into the background on this loan type, short-term personal loans are small loans that are typically repaid in a year or less. With no collateral being required, in most cases, the loans almost always have a far higher interest rate than other loan types. Proof of employment, income level, current address, credit history, and other types of personal and financial information will all be required.
What are short-term loans used for?
In most cases, short-term loans are used to pay off quick expenses that arise and need to be handled in a rapid manner. Items such as car breakdowns are a very common example of what short-term loans may be used for. However, while these loans are appealing for short term purposes, they often come with high interest rates that make them extremely challenging to pay back.
Types of short-term loans
There are a variety of short-term loan options available, some of which should be avoided and some of which might be considered depending on your situation:
1. Payday loans
One of the most common, and most dangerous, types of short-term loans are payday loans. This type of loan provides enough funds to cover expenses, with the repayment being due at the time of your next paycheck. However, the interest rate charged on these loans is often so high that if you cannot pay it all back by your next paycheck, you can easily fall into a cycle of debt.
Related: How to Get Out of Payday Loan Debt ?
2. Car title loans
A car title loan allows you to take out money based on the value of your vehicle, typically 25-50% of its market value. You must own the vehicle in its entirety to take on such a loan. The major downside to this loan type is that it has a small repayment window of a couple of weeks, in most cases, and a high APR that can potentially be in the hundreds, which means that paying it all back in time is a challenge. Additionally, if you are unable to pay, you stand at risk of losing your vehicle.
3. Bank overdrafts
Most banks offer overdraft services that allow a payment to go through, even if you do not have the money in your account. Overdraft charges should be handled quickly to avoid high fees and interest rates. While most banks do have overdraft protection, the costs of overdraft can still quickly pile up.
Possible risks of short-term loans
The risks of short-term loans are plentiful which is what makes short-term finance risk so prevalent. Outlining these risks can help make any borrower a more informed decision-maker:
1. High interest rates
Since many short-term loan options provide quick access to cash, minimal information during the application process, and quick repayment periods, the APR is usually extremely high. If you are unable to pay back your short-term loan in a single repayment period, the cost can become far too much to bear.
2. Excessive fees and penalties
Oftentimes, short-term loans will come with excessive penalties for late payments or large fees such as an origination fee. These can make the true costs of the loan far more expensive than you originally thought, in addition to the large interest rate.
3. Credit score repercussions
Another major risk of short-term loans, in the event of a failure to repay, is the fact that your credit score can seriously suffer. Avoid any late payments on all loans, not just short-term loans, to be sure your credit score stays stable when taking on debt.
4. Habitual borrowing risks
While the idea of receiving necessary funds in the short-term is extremely appealing, it can lead to habitual borrowing. Even if you can pay off the loan the first time around, the thrill of being able to take on whatever the expense was and having access to the funds immediately could lead a person to think they can take on the debt again.
Alternatives to short-term loans
The serious personal loan risks that come with short-term loan borrowing can easily become overwhelming. Fortunately, there are several other borrowing options that can be utilized:
1. Friends and family
Assuming they are willing to provide the funds, friends and family members can be an excellent alternative. Just be sure not to place a strain on any personal relationships for financial reasons. Only borrow what you know you can pay back to help ensure this.
2. Using equity in your home
A home equity loan might be a safer and longer-term option for borrowing to consider. This type of loan works by allowing a borrower to take out a lump sum of money valued against the amount of equity they have in their home. These loans have longer tenors that allow a borrower more time to make payments, and the interest rate is typically more favorable as it requires collateral. With that said, the presence of collateral means that the loan itself carries some risk if you are unable to repay it.
Related: Home Equity Loan and HELOC
3. Credit cards
For short term expenses, credit cards have far more favorable interest rates than short-term loans. Assuming the expense you wish to pay is within your credit limit, using a card instead of a loan may provide you with better terms.
4. Buy now, pay later
Many companies offer buy now, pay later plans that allow you to make your purchase and then begin repayments at some point in the future. The dangers of personal loans in the short term are the high APR that often comes with them. Buy now, pay later plans typically have larger interest rates than other borrowing alternatives, but they are far less than options such as payday loans.
5. Salary advances
Some employers may allow you to take an advance on your salary if you provide a good enough reason for why you need the cash immediately. Submit a formal request to your employer and see if they agree with your request to gain access to the funds.
6. Personal line of credit
Finally, a personal line of credit is an excellent strategy for gaining access to funds. As opposed to a single lump sum, a line of credit provides a borrower with access to funds up to a certain amount. Assuming a borrower takes out as much as they are allowed to borrow, they can pay it down and begin borrowing up to that amount again.
Learn more: Personal Line of Credit
When looking at what a short-term loan is, it’s crucial to consider the pros and cons. The biggest pro of short-term loans is the fact that you gain quick access to funds. However, the major drawbacks are the high APR that often come with the loan and the short repayment period.
The appeal of short-term loans is the quick access to funds which can be used for expenses that may arise. However, this can quickly lead to a cycle of debt if you are unable to make the necessary payments on the loan.
In most cases, long-term loans will come with lower interest rates and smaller monthly payments. Unless you need access to a specific amount of cash and can afford short-term payments, a long-term loan is typically the better choice.
One aspect of a short-term loan definition is the fact that they are typically extremely expensive. The reason for this is that short-term loans have short repayment periods, are often unsecured, and typically do not require much information to be given on behalf of the borrower.
In general, the tenor for short-term personal loans ranges from a couple of weeks to around a month. The major risk of short-term financing is that these loans are required to be repaid so fast, which can make acquiring the cash difficult.