Understanding the Risks of Short-Term Loans

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If you’re in need of quick cash but might have trouble borrowing money through traditional means, a title or payday loan might sound like the light at the end of the tunnel — neither requires a stringent approval process and you can get the money quickly.

Although you can easily access these short-term loans, they come with a high level of risk. The biggest risk is that like many payday loan borrowers, you could end up in a nightmare debt cycle, having to pay fees and interest charges that would quickly eclipse the amount of cash you borrowed in the first place.

Keep reading to learn more about the risks and costs associated with some common short-term loans. Next, discover alternatives that can help you get through your financial crisis.

Common types of short-term loans

When you need financing quickly, there are several options to choose from. Before you take out a short-term loan, be sure you understand how long you have to repay the funds, how much you can borrow, and, of course, how much it will cost you.

Payday loans

Typical Term LengthAvg. Loan AmountAvg. Financing Charge

14 days

$500

$10 to $30 per $100 borrowed

Payday loans are high-cost, small-dollar personal loans that become due in a lump sum — typically on your next payday. You can find these types of loans from storefront or online payday lenders.

Many states set limits on the amounts of payday loans lenders can offer, according to Consumer Financial Protection Bureau, and the most common payday loan amount is $500. Loans are available above and below that, depending where you live.

Lenders generally require you to write a predated check for the amount you want to borrow — including fees — or they might ask you for authorization to electronically withdraw money from your bank account.

The lender gives you the funds, then holds the check until the loan is due. If you can’t repay it on deadline, the lender can cash the check or take money out of your account. You can choose to extend the loan term — but that’s when the debt trap begins. You’ll likely incur additional charges each time you roll over your debt for another payday period, making it that much more difficult to pay off the balance.

The average loan term ranges from two to four weeks. Many states have laws that cap payday loan fees, which generally range from $10 to $30 for each $100 borrowed. A typical, two-week payday loan with a $15-per-$100 financing fee translates to an annual percentage rate of almost 400%.

Check out this map by Center for Responsible Lending showing interest rates on the typical payday loan in each state. CRL is a nonprofit, nonpartisan research and policy group.

Stuck in a payday loan trap? Here are the ways out.

Short-term installment loans

Typical Term LengthAvg. Loan AmountTypical APR

Two weeks to several years

$1,291

197% to 369%

Installment loan borrowers typically get fixed-rate loans with fixed payment schedules.
Understand that many small-dollar installment loans are really high-cost payday loans in disguise. In recent years, payday lenders have moved into the installment loan business to skirt heightened regulations regarding payday loans. Instead of issuing high-cost payday loans, these lenders might offer installment loans, but charge high upfront fees to get around interest rate caps set by state regulatory bodies.

The CFPB reports that the average size of installment loans borrowers take is $1,291 and APRs range from 197% to 369%. Installment loan terms are longer than payday loans and can have terms of up to several years.

According to the Pew Charitable Trusts — an independent, nonprofit policy think tank — lenders in 19 states issue short-term, payday installment loans: Alabama, California, Colorado, Delaware, Idaho, Illinois, Kansas, Missouri, New Mexico, North Dakota, Ohio, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia and Wisconsin.

Car title loans

Typical Term LengthTypical Loan AmountsTypical Financing Charge

15 to 30 days

$100 to $5,500
(25% to 50% of the vehicle’s value)

25% per month

A title loan is another kind of expensive, short-term loan, but it’s secured, which means you have to put up collateral to get the loan. For example, title lenders use your car’s title as a collateral.

You typically have to own your car outright to be eligible for a title loan, but some lenders offer them if you have equity in the vehicle or even a clear title — you just need to have enough car equity to cover the loan. Car title lenders usually make loans that equal 25% to 50% of the car’s value. Title loan term lengths generally run 15 or 30 days. On average, the loan amounts range from $100 to $5,500, but some lenders will issue these loans for $10,000 or more, according to the Federal Trade Commission.

Lenders charge an average of 25% as a monthly financing fee, which adds up to an APR of at least 300%, according to the FTC. You also might be on the hook for additional fees, depending on the lender.

Like payday loans, if you can’t repay a single-payment title loan on time, you might choose to extend your loan term, which will result in more fees. Some car title loans have longer loan terms and you can repay them in installments. Vehicle title installment loans are available in 18 states, some of which allow both single-payment and installment loan structures, according to the CFPB. If you can’t repay the loan at all, you risk losing your car — the lender can legally repossess to recoup the money you owe.

Pawn shop loans

Typical Term LengthTypical Loan AmountsTypical Financing Charge

30 to 90 days

$150

36% to 100%

Pawn shops offer collateral-based loans. You bring in something of value — think jewelry, musical instruments, tools or other household or personal item — and the pawnbroker lends you money based on the value of your collateral. He or she holds onto your collateral until you repay the loan.

The average pawn shop loan amount is $150, according to the National Pawnbrokers Association. Borrowers typically have 30 to 90 days to pay back their loans and get their items back. The cost of these loans varies, depending on state law cap rates and individual shops’ practices. Some pawn shops charge storage fees and insurance fees. Christopher Peterson, director of financial services and senior fellow at the Consumer Federation of America, estimated that on average, these loans’ APRs range from 36% to 100% — or more.

Peterson said pawn shop loans’ APRs are consistently lower than payday loans’, but well-above average credit card interest rates of 15.5%. If you can’t repay your pawn shop loan in full, you lose your collateral, but your loan will be marked as paid.

Learn more: Why are short-term loans risky?

You’re likely entering the danger zone if someone offers a short-term loan that comes with an APR higher than 36% — the benchmark for affordable small loans — no matter how the loan is structured.

Here are just a few reasons to be wary of short-term loans:

They can quickly balloon over time

Payday, title and payday installment loans are often called predatory loans because they are very different from healthy, small-dollar loans that provide wealth-building opportunities or income-smoothing possibilities — these risky, short-term loans are designed to profit based on borrowers’ inability to repay them. That way, high-cost lenders can keep charging fees.

“There’s no shortage of personal stories or accounts of individuals taking out a few hundred dollars, like $200 or $300, and actually end up paying over $1,000 just in fees,” said Scott Astrada, director of federal advocacy for CRL. “And their principal has never even [gone] down by a dollar.”

Here’s an example of what can happen with these types of loans: Say you need $500 today and you take out a loan with a $15-per-$100 finance charge. That means you owe $575, which is due on your payday in two weeks.

“A person who doesn’t have a $500 today is not going to have $575 in two weeks,” said Ed Mierzwinski, senior director of the Federal Consumer Program at U.S. PIRG, a grassroots consumer program.

If you keep rolling it over by paying another $75 every two weeks, three pay periods later you’ll end up incurring a shocking $225 fee on a $500 loan, which equates to a 391% APR. “That’s a debt trap,” Mierzwinski commented.

Installment loans might sound like a safer bet because you’re making fixed monthly payments over a set period of time. But they can also be unaffordable, Peterson said.

“You could have a 500%-interest-rate-two-week payday loan that you just pay the interest on and you roll over multiple times, or you can have a 500%-interest-rate-year-long installment loan where you just pay interest and never decrease the principle,” Peterson said. “If you just take the money and don’t pay attention to the labels or the ink on the paper for the contract, these are essentially the same loan.”

The CFPB study found that nearly a quarter of payday installment loans end up in default. Of all the short-term products, online payday installment loans have the highest default rate — 41%.

Your bank account might be at risk

Short-term loans might have a domino effect on your financial security.

“It’s not uncommon for the debt trap not only to threaten the financial security of the borrower, but to have far-reaching, devastating effects on the whole financial life of the borrower,” Astrada said.

To take out a payday loan, you have to have a bank account; often, you have to give lenders access to your bank account to withdraw your payments (or give them a predated check). Lender is entitled to cash your predated check if you don’t pay them back. That could lead to overdraft fees, bounced check fees, your bank closing your account — all of which could significantly damage your credit. Some risky loan borrowers even end up in bankruptcy.

You could lose your possessions

To get a short-term title loan, your collateral is your car. Keep in mind that you lender is within his or her legal rights to take possession of your vehicle if you default on the loan.

“For $200, $300 or $500 that you need, you are putting your car that could be worth $2,000 or $3000 at risk of being repossessed by the high-cost predatory lender,” Mierzwinski said.

Moreover, if a lender takes possession of your car, you won’t be able to get to work, which will eventually affect your ability to repay the loan. Approximately 22% of car title installment loans end in default, and lenders repossess about 8% of those, according to the CFPB.

When you take out a pawn loan, you might risk losing your collateral, but at least nothing will happen if you walk away from the debt. That’s why pawn loans are relatively safer than other high-cost short-term loans. Peterson suggested that if you want to take out a loan from a pawn shop you select the collateral that you can live without — think twice before you pawn a family heirloom.

When can short-term loans be a good idea?

There are countless reasons — many beyond your control — you might need money fast. Medical emergencies, unexpected job loss or car repairs can easily send your finances spiraling. Before you take out a short-term loan, first ask yourself whether it’s necessary to borrow some quick cash for the expenses. For example, it’s not a good idea to take out short-term loan for a want, rather than a need, like a lavish vacation.

“If you’re taking out small-dollar loans that just simply pushes the problem forward in terms of having more expenses and income, that’s a dangerous situation because then you’re not actually addressing the issue,” Astrada said.

You should consider short-term loans only when it’s absolutely necessary, such as for a true emergency. If you do decide on a short-term loan, avoid the high-cost, predatory ones. Instead, shop for the lowest APR you’re eligible for and borrow only as much as you need. Read on to find some better, safer alternatives options with reasonable interest rates.

Where to find a good short-term loan

Start with your local credit union or community bank

Plenty of community banks and credit unions offer personal loans or small-dollar loans with much lower interest rates than payday or title loans. In addition, these types of financial institutions are much better regulated than high-cost lenders.

For example, all federal credit union loans have an 18% interest cap, with one exception — Payday Alternative Loans, which have interest rates capped at 28%.

Look for credible, online lenders that offer lower-APR loans

Some banks and nonbank, online lenders also make decent installment loans, even for people with not-so-great credit scores. There are decent personal loans for people with bad credit. Online lenders typically offer loans to borrowers with minimum scores of 600. The higher your score, the better rates you’ll likely get. The exact products lenders offer you can depend on your credit score, credit history, income and where you live, but the APR should not exceed 36%.

Compare lenders on our personal loan marketplace.

When considering a short-term loan, there are a few things you must avoid. Because you don’t want to get into a bad cycle of debt, consider these points when you’re choosing a loan product:

1. The total loan cost
The main difference between a small-dollar loan that’s predatory and one that’s beneficial to a consumer is the interest rate. “Anything over 36% is very, very high-cost credit,” Astrada said.

2. How many questions the lender ask you
Risky loan lenders don’t ask for much information about your finances and the process is quick and easy. Legitimate financial institutions, however, have strong underwriting standards and typically access your personal and financial information to determine your ability to repay.

“[The lack of strong underwriting], where you can click three buttons online, walk through a store and walk out in five minutes. Yes, it’s more convenient, but it’s also like the bait of getting into one of those debt traps,” Astrada said.

3. Additional fees
Be wary of a host of tangential loan charges, such as prepayment, membership, convenience or origination fees. The loan itself might be small, but if a lender includes points and fees in the APR, your cost of borrowing can skyrocket.

4. Transparency
Steer away from products that don’t offer disclosure on rates and terms. If the lender is not transparent or ambiguous about additional fees, loan terms and your APR, consider it a red flag.

Alternatives to short-term loans

You might not have to take out a payday loan if you take certain actions. Consider these:

Contact your creditor to make a payment plan. If you know you might miss payments or have already missed some, don’t panic. Contact your creditors first. Some might work out a payment plan with you, especially if you have an emergency. For example, many utility companies and hospitals offer lower interest — even 0% — payment plans to make sure that you can pay past due balances over the course of several months.

Shop around for the lowest-cost loan. Check with credit unions and community banks to see if you qualify for a small-dollar personal loan. Also search for credible financial companies offering installment loans with lower APRs.

Ask friends and family for help. Don’t be embarrassed to ask friends or family if you need a quick, short-term loan. A Pew Charitable Trusts study found that many borrowers trapped in payday-loan debt cycles eventually got help from friends and families. You’re way better off asking for help from them instead of getting in over your head with a predatory loan.

Take a credit card cash advance. When you borrow cash against your credit card’s line of credit on your credit card, it’s called a cash advance. Unfortunately, cash advances often come with high interest rates and additional fees.

In fact, a cash advance APR is typically 5% higher than the APR for purchases. On top of that, you’ll incur a 3% or 5% fee on the amount of each cash advance you take. It’s not an ideal solution, but still likely cheaper than a payday or title loan in the long run.

Make a budget and save for emergencies. Look at your income and expenses and make sure you don’t spend more than you earn. Avoid unnecessary spending. At the same time, build some savings so that next time an emergency arises, you have a cushion to fall back on instead of turning to credit for help.

The bottom line

Say no to costly short-term loans. Don’t fall for the convenient, quick money — those predatory loans can cost you a great deal in the long run. If you do a need short-term loan, shop around for the lowest-cost one you can find. Try local banks, credit unions and credible financial companies. If you can’t secure a loan because your credit is bad, you have no income and you don’t own anything that qualifies for collateral at a pawn shop, you may need to seek alternatives as mentioned above, but a three-digit, payday or title loan isn’t going to fix your problem.

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Shen Lu
Shen Lu |

Shen Lu is a writer at MagnifyMoney. You can email Shen Lu at [email protected]

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