Introduction to Loans
Yes, short term loans do have higher interest rates than their counterparts. However, to avoid short term loans based on this alone, would be an over simplifying the product. For starters, loans come in many different forms, varying in terms of interest rates, duration, principle sums and background checks. Choosing the right loan for your personal finance or business venture can be a tricky issue. In fact, loans have traditionally been viewed negatively in large part due to a lack of understanding of the product.
Many borrowers jump into loan agreements without having planned for repayment and interest costs. In particular, an instant short term loan is often misunderstood and rushed into. The mechanisms of this type of loan are not inherently bad, and they serve particular needs. However, where the borrower is negligent in reading the fine print, they may receive a shock from finding the cost of interest. To help improve the understanding of this product, we have compiled a guide to short term loans, within which we will explain why higher interest rates are expected.
As their names imply, the clearest difference between short term and long-term loans lies in the length of their contract. Typically, short term loans last for a period of 3 to 18 months, though more commonly less than a year. Conversely, long term loans are designed to be paid off in a longer period of time than a year.
The longer the term of the loan, the stricter requirements are applied in terms of eligibility. This is factored in to protect leaders from the greater risk of non-payment within the larger time period. Lenders need to be highly confident in the borrower’s capability to repay in full and on time. Practically, this results in only individuals with high credit scores or established businesses being able to borrow long term loans. On the other hand, short term loans have fewer eligibility requirements as lenders perceive less risk in the loan.
Short term loans amounts are lesser than long term loans as no lender would be keen to harbour the risk of lending a large sum of money within a short period of time. Due to time constraints, lenders would not have the resources needed to conduct proper loan eligibility checks. As such, they would not have sufficient confidence in the ability of the borrowers to avoid defaulting on such a loan.
Since lenders are unable to impose strict requirements for short term loans, the risk undertaken is addressed through higher interest rates. The additional interest protects the lender’s interest by ensuring that the he/she will be able to recoup most of their loan sum even if the borrower eventually defaults. Additionally, the interest rates are also a function of the speedy approval of funds.
At this point, it is important to clarify that the higher interest rates in short term loans do not necessarily make them more costly than long term loans. Rather, long term loans generally cost more as the longer a loan is held onto, the more money is paid for interest.
Secured or Unsecured
Secured loans are a category of loans in which an asset is pledged as collateral in order to secure the loan. If the borrower defaults on the loan, the lender will have the right to repossess the asset. In the case of short-term loans, the urgency of the situation usually stipulates that no asset would be used as collateral. Instead, higher interest rates are raised to protect the lender against the incremental risks.
What are Short Term Loans Good For?
The type of loan that you should take depends largely on your personal or business needs. Short term loans are used in a variety of situations such as to meet a spike in seasonal demand. For example, during the holiday season, demand for a company’s goods may exponentially increase. If the company is not prepared and does not have the capital to meet the demand, a short-term loan could help inject some much-needed capital. Another situation would be for emergencies whereby urgent funding is needed to pay for one’s hospitalization bills.
Leveraging Debt with Long Term Loans
If you are looking to make a long-term investment, then a long-term loan could allow you to leverage the debt and thus make a net earning. In layman’s terms, if the interest from your investment out performs the interest from your debt, you would have successfully made a profit from the borrowed sum. Additionally, the lower interest rates of long-term loans also enable you to have increased liquidity which may be needed for day-to-day operations.
Is it Possible That You Don’t Qualify for Short Term Loans?
Although short term loans have relatively lower barriers to entry, lenders will not be keen to extend a loan if you have a high debt to income ratio. There is an implicit assumption that you will not be able to pay back the loan as you are not earning enough in comparison with the rising personal debt.
Avoid Short Term Loans to Pay Debt
For chronic debtors often borrow short term loans as part of a refinancing plan to pay off outstanding debt. This is a risky action, even more so than the leveraging act mentioned before. Often times, since short term loans have higher interest rates, borrowing to pay off immediate debt will result in the debtor owing even more.
What Loans are Suitable for You?
As seen in the previous paragraphs, there are many variables to consider when determining the type of loan you wish to undertake. A general rule of thumb that can be applied is to get the shortest possible loan term without sacrificing the objective of the borrowed sum. This will help to keep overall cost down.
If you are familiar with financial calculations, you could also find the net present value of the loan to determine its profitability. This would be the most accurate method of determining whether the short-term loan’s interest rate is payable by you. All in all, you should always do your due diligence before approaching a low interest money lender to get a loan.