Short-Term Loans: Understanding the Risks

Short-term loans can look awfully tantalizing when personal finances hit the wall and consumers need money fast. When facing cash-strapped challenges or poor credit, an installment loan or payday loan promises immediate, short-term relief, albeit at a huge cost in terms of interest and penalties. When used repeatedly or rolled over into additional debt, some short-term loan products can send borrowers into a financial death spiral.

Short-term loans are offered in two major product groups, installment loans and payday loans. Let's examine the details of each type of loan, their risks and alternatives:

Installment Loans

Installment loans are made by banks, credit unions, and private lenders in amounts typically ranging from $1,000 to $15,000. Borrowers repay the loan on a routine schedule, often by deductions from their checking account, until the principal and interest are retired. The cost of these loans can be high. For each $100 they borrow, consumers should expect to pay from $20-$40 to the lender. The installment lender charges a fee that is included in the repayment schedule. In some cases, the loan may be paid in full at the end of the term.

Installment loans can provide a short-term solution for college students, consumers facing exorbitant overdraft charges, people needing to protect their credit or avoid high late fees on other accounts. The APR can be in the 550% range, but is still less over the 2-4 week period than the consumer would pay on a credit card late fee (950+%).

Alternatives: Seek longer term personal loans or secured loans, get overdraft protection on a checking account, ask for employer advances or take out new zero-interest credit cards. Look into receiving a line of credit from a financial institution.

Payday Loans

According to research by the Pew Charitable Trust, every year 12 million Americans take payday loans. A payday loan gives borrowers a personal cash advance that is secured by personal check or electronic transfer. These loans are especially attractive to borrowers with poor credit since no credit check is required. At the end of the advance period, the lender cashes the check, which includes the service fee. The APR on payday loans is extremely costly, upwards of 390% percent. If the loan is extended, consumers need to pay additional finance charges as high as 60% on the loan amount.

Payday loans can help with an immediate cash emergency such as medical expenses, but only if they're paid off in time by the following month's paycheck. The Pew researchers found that many Americans are just using payday loans to repay existing payday loans, settling deeper in debt each month.

The Federal Trade Commission warns against the pitfalls of payday loans and suggests consumers search for alternative credit offers with the lowest cost. Borrowers can shop for free offers with LendingTree's loan comparison tool.

Alternatives: Establish payment plans with existing creditors. Seek Payday Alternative Loans (28% APR) through participating credit unions. Participate in debt consolidation/debt counseling programs.

Depending on their credit, consumers may find that the best alternative to short-term borrowing is to seek a personal loan with longer terms. With APR as low as 5.99%, an unsecured personal or signature loan with terms from two years to 60 months may provide sufficient repayment time to avert the quagmire of debt associated with repeated payday loans.

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