Understanding the Risks of Short-Term Loans
For many people, sometimes a situation arises for which you need access to cash fast. Whether it’s an emergency car repair, having to book an unexpected trip to care for a sick relative or a temporary loss of income (such as the workers furloughed in the recent government shutdown), if you don’t have enough cash to cover expenses, you might consider applying for a short-term loan.
Although it’s only meant to be a temporary solution until you’re back on your feet financially or to tide you over until your income is restored, you must be cautious. That’s because, in many cases, short-term loans turn out to be a poor choice that can make a bad situation even worse.
Here’s what you should know before you take out a short-term loan.
- What is a short-term loan?
- When is a loan term too short?
- Watch out for risky short-term loans
- How to get a reputable short-term loan
What is a short-term loan?
Short-term loans are just what their name implies: a means for borrowing a lump sum of money that must be paid back in less than one year. Some short-term loans can be even shorter, with repayment terms of one month or less.
“Typically, short term loans are very, very expensive,” said Michael Gerstman, CEO of Gerstman Financial Group in Dallas, Texas. For starters, interest charges can be 15% or higher, and there’s sometimes an additional upfront origination fee tacked on to the amount you’re borrowing.
In some cases, a short-term loan can serve the purpose of providing relief or a financial cushion over the course of a few months, but reputable short-term loan products are few and far between, Gerstman warned. And, the better loan products will likely require you to meet certain eligibility requirements, such as having a respectable credit score. (It’s worth noting that if your credit score is suffering, you can take steps to improve it, such as by utilizing a credit repair service.)
When is a loan term too short?
In general, the shorter the term, the more financial pressure there will be to pay it back in full — and soon. The payments will be higher, and, usually, so will the interest rate and other fees. “These loans are always to the benefit of the lender,” Gerstman said. “It’s more than caveat emptor. Some of these things should be illegal.”
Consider this scenario: You work on commission and are in a slump, so you borrow a lump sum (plus interest and fees) to cover your bills this month. When next month rolls around, the income you make is swallowed up by this loan. Suddenly, all of your regular bills are due again, plus the new loan payment. If you can’t pay off your loan, the lender adds on more interest, driving your balance owed even higher. Suddenly, you’re further behind than you were before you started.
Watch out for risky short-term loans
Not all short-term loans are created equal, and some are riskier than others. Unfortunately, there are many predatory lenders who take advantage of people who are in dire need of cash flow. And with other options, you run the risk of staying in a cycle of debt.
Here are three examples of riskier types of short-term loans:
Payday loans are, in essence, an advance on your paycheck. You get cash now and give the lender a post-dated check for the amount borrowed, plus interest. The problem is, come next payday, many people aren’t able to pay the debt, and end up continuing the loan for another pay period — thus adding another round of high interest.
“It’s a complete win for the lender, and the borrower is typically going to get hurt in this transaction,” Gerstman said. In fact, payday loans are so dangerous that they are actually illegal in some places, such as New York.
Credit card cash advance
Although not as shady as payday loans, taking a cash advance with your credit card can still be a costly move. You’ll begin accruing interest form the day you take the cash advance (so no grace period), and that interest rate is usually north of 20%, Gerstman said. What’s more, you’ll also be charged a 2% to 5% transaction fee.
If you’re already carrying credit card debt, bringing a cash advance into the mix will make it even harder to dig out.
Car title and pawn shop loans
With these type of loans, you’re essentially putting up collateral for borrowed cash, meaning if you can’t pay back the debt in 30 days (or whatever the term is), you lose your asset. Car title loans and pawn-shop loans are similar, in that if you fail to pay, you could end up losing your property. The car title lender can wind up repossessing your car.
“There are always strings attached, and interest rates on an annualized basis could be hundreds of percent,” Gerstman said.
How to get a reputable short-term loan
Although short-term loans are never ideal, when personal loans are taken from a legitimate bank or lending institution, they can allow you to get an infusion of cash quickly with more favorable terms than what’s described above.
“The pros are that it’s creating cash where cash is needed, and they’re fairly easy to come by,” Gerstman said. As long as you can show proof of income and meet other criteria, you can generally be approved for a small amount quickly.
Despite being in a pinch, it’s in your best interest to still take the time to compare fine print details so you can find the best short-term loan rates and terms available.
While short-term loans should never be your first choice in dealing with a temporary financial setback, if you go with a product that offers ample time for you to pay it back and favorable terms, it might be a good solution to help you get by.