The Hidden Costs of Short-Term Loans
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Having an emergency fund and savings is an essential part of any good financial plan because it assists you in times of urgent need. However, what do you do when those options aren’t sufficient? You have to then look for financial options such as short-term loans to meet those unexpected expenses.
Short-term loans are great loans for an emergency as they provide you with urgent cash, but there’s more that you should know about them before you take one.
They’re a good way to cover the immediate expenses if you’re satisfied with the amount you’re receiving and confident that you can pay it off on time. However, they can quickly become a financial nightmare if you’re unable to meet the repayment terms.
Let’s take a look at how short-term loans work and what their hidden costs are.
Understanding Short-Term Loans
Short-term loans, also known as payday loans, are designed to help you cover your immediate expenses. However, if not managed properly, they can leave you vulnerable to long-term debts. These loans typically offer small amounts and have a short repayment period, ranging from a few weeks to a few months.
Borrowers are easily tempted by the ease of access to such loans but are often unaware of the hidden costs that come with them. Let’s understand what these costs are and how they can affect you.
1. High Interest Rates
Short-term loans are an expensive form of borrowing and are better seen as a last resort than a first solution to funding issues. In our country, payday loans can have an Annual Percentage Rate (APR) of around 1,250%. However, due to regulations by the Financial Conduct Authority (FCA), the daily interest rate of short-term loans is capped at 0.8% and the maximum fee in case of late payment is capped at £15.
For example, if you borrowed £300 for 30 days and made the repayment on time, the maximum interest you’d have to pay would be £72. This is much more than you would have to pay if you borrowed money on an overdraft, credit card, current account, or via a personal or unsecured loan.
2. Impact on Your Credit Score
If you fail to repay your loans on time or take another loan to cover an existing one, it will negatively impact your credit score. As your credit score drops, your access to financial products and services such as mortgages and car loans becomes limited. Additionally, the interest rates you get when borrowing on a low credit score are much higher than if you have a healthy credit score.
3. Risk of Falling into a Debt Trap
Short-term loans provide quick relief but their high rates of interest make repayments a challenge that spirals out of control if not planned around strategically.
You may find yourself taking out a new loan just to pay off an older one to remain afloat. After a certain point, it can start seeming impossible to crawl out of the debt, requiring you to take drastic measures like declaring bankruptcy. This can in turn cause you to lose your non-essential assets such as your property.
4. Stress and Anxiety of Repayment
Not all the hidden costs that come with short-term loans are monetary, as this one takes a toll on your mental and emotional well-being. When the loan interest and other debts pile up, it can have long-lasting effects on your overall health.
You can’t spend money on your own terms or live the lifestyle that you desire anymore because you’re too anxious about the upcoming deadline. The emotional strain of dealing with debt often goes unrecognised, but it can be just as significant as the financial burden.
How Can You Avoid Paying These Costs?
1. Explore 0% Interest Credit Cards
Before committing to short-term loans, research and educate yourself on credit cards that charge no interest up to a certain time period. Depending on your credit score, you can get up to 22 months of 0% interest on your credit cards from some credit unions and banks, such as Barclaycard and NatWest.
2. Mandatory Credit Check When Borrowing
If it is an absolute necessity for you to take a short-term loan, make sure that the lender you’re borrowing the money from is performing a credit check. Lenders who claim to not do these checks are generally irresponsible with their lending and aim to trap you.
3. Check Eligibility for 0% Interest Government Loan
Similar to 0% interest credit cards, the government provides budgeting loans to people on income-based benefits such as pension credit, support allowance, jobseeker’s allowance, or universal credit. This is an interest-free loan of up to £812 depending on your marital status.
4. Borrow from Friends or Family
While this may be difficult and make you feel uncomfortable, borrowing from people you trust and who are close to you is a better alternative to short-term loans. The only thing you need to do is agree on clear repayment terms and abide by them to avoid any potential conflicts with the person you’re borrowing from.
Short-Term Loans—Should You Take Them?
Unless you have exhausted all your options and are fully confident about paying off the short-term loans that you’ll be taking, it is better to look for alternatives. There are multiple hidden costs that come with short-term loans, and they can all cause you significant financial strain in the long run.
Take the time to research these alternatives so that you can make informed, strategic decisions before falling into a debt trap or letting your credit score get affected.
