Short-Term Loan Advantages and Disadvantages

What are short-term loans?

Short-term loans are smaller loans that must be repaid quickly, typically within six months to a year. Common types of short-term loans include payday loans, online personal loans and invoice financing.

The short repayment period and smaller loan amounts make these loans less risky for lenders, which leads to more relaxed qualification standards and faster processing.

Advantages of short-term loans

Short-term loans are a convenient way to get some quick cash, and they can benefit you in several ways:

• Less time for interest to accrue: Even though the interest rates can be high, the loan is paid off quickly. This means the balance doesn't have time to accrue very much interest.
• Fast funding: Since underwriting is easier for short-term loans, lenders can move quickly. There’s less risk because the borrower's financial situation is unlikely to change over such a short period of time.
• Easy qualification: Short-term loans are often smaller amounts, and the quick return of funds makes them less risky, which makes them easier to qualify for.
• Improved cash flow: Individuals can use short-term loans to cover shortfalls that can occur between paydays, particularly in the event of unexpected expenses. Businesses can use them to cover expenses that will generate future revenue, such as buying inventory or supplies.

Biggest benefits: fast applications and easy approvals

With many types of short-term loans, you receive your funds immediately with limited application requirements. For example, pawn shop loans or title loans don't require an extensive application, and you'll receive the funds as soon as you provide the collateral.

Personal loans or short-term business loans require applications, but many lenders process them quickly and provide funds within 24 hours. This is because the loan amounts are often small and the repayment periods are short.

Darren Burgess, owner of Yup Loans, an online personal loans platform, said: “Short-term loans are an ideal way to raise cash in an emergency, as the money can be with you the same day or soon after. The application process is faster and less stringent than traditional loans, making them accessible even for people with less-than-perfect credit.”

Disadvantages of short-term loans

While short-term loans can be convenient, they are also expensive and can trap borrowers in a cycle of high-interest borrowing.

• High interest rates and fees: Short-term loans often have high interest rates — sometimes notoriously high.
• Can trap people in a cycle of debt: If you’re having trouble getting by until your next paycheck, it’s tempting to take out a short-term loan. However, if the loan charges fees or interest, this will leave you with even less money in your next paycheck, requiring you to take out an even larger loan next time. These conditions can create a cycle of debt that’s hard to escape.
• Small loan amounts: If you need a larger amount, a short-term loan may not be suitable. Longer-term loans will likely have lower interest rates and more flexible terms, making them better for larger amounts.
• Short repayment periods: These loans must be paid back quickly, which often means higher monthly payments and less flexibility. That can put borrowers in a tough financial position.

Biggest drawbacks: high interest rates and fees

Short-term loans don't leave a lot of time for interest to accrue. Lenders make up for this by charging high interest rates and fees.

Also, loans with relaxed or nonexistent application procedures pose a higher risk to the lender. The less the lender knows about the borrower, the higher the risk. Again, lenders must charge higher rates and fees to compensate them for this additional risk.

For example, a payday lender may charge $20 per $100 borrowed. If you took the loan for 14 days, your annual percentage rate (APR) would equal 521%! In comparison, credit cards, even those marketed to people with low credit scores, rarely charge over 30% APR.

When to consider a short-term loan

Short-term loans are beneficial in situations where you need money quickly and have a clear repayment plan. For example, a contractor might use a short-term loan to purchase cabinets and tile for a kitchen remodel that will be paid in full once the job is finished.

Short-term loans can also help cover emergency expenses, such as car repairs. Taking a short-term loan can get your money quickly, and then you can refinance to a longer-term loan later if needed.

Many individuals use short-term loans to bridge a financial gap until their next payday. Short-term loans can help get you through, but if this is a frequent occurrence, you may want to consider a more permanent solution. It's easy to get caught in a cycle where you rely on short-term loans more and more.

» EXPLORE: Top-ranked options for fast cash

Types of short-term loans

There are several different types of short-term loans for both individuals and businesses.

• Payday loans: Payday loans offer quick cash to those who need funds until their next paycheck. The entire loan, plus interest, is due on the borrower's next payday. It's common for lenders to have access to the borrower's bank account and to take the payment directly from the account.
• Title loans: Title loans are similar to payday loans, but you secure the loan with the title of your car. If you don't repay the loan, the lender can take possession of your car and sell it in order to repay the loan. Depending on your state's laws, the lender may or may not have to give you the difference between the loan amount and the sale of the vehicle.
• Pawn loans: A pawn shop loan is a short-term loan that is secured with an item of value that you can leave with the pawn shop. If the loan isn’t repaid, the pawn shop becomes the owner of the item and any funds they receive from selling it.
• Online loans: Some online lenders offer short-term personal loans. These lenders can approve applications quickly, and the money can arrive in your bank account within a few days.
• Invoice financing: Businesses can receive funding based on accounts receivable. A business can borrow money based on unpaid invoices, and the loan is due when the invoice is paid.
• Merchant cash advances: Businesses can take a loan that is repaid with a percentage of future debit and credit card sales. Each time a card is processed with the merchant, the lender gets a set percentage until the loan is repaid.
• Trade credit: Businesses receive goods or services without the immediate exchange of money. Instead, an invoice is sent, and the business has 30 or 60 days to pay the invoice.