They’re the quickest way to get cash, but they’re also the most likely to leave you in the poor house. Borrow money safely by learning about the huge costs of short-term loans.
Image source: Getty Images.
When you’re in a jam financially, ads for short-term loans, most commonly payday loans and car title loans, can sound incredibly appealing. You can get hundreds or thousands of dollars on the day that you apply, and you can even get that money with a bad credit score.
Unfortunately, these types of loans are much riskier than their ads let on, to the point where they’ve even been banned in several states. Before you go near a payday or title loan lender, you need to know how they operate and why they’re so dangerous.
How short-term loans work
With a short-term loan, you’re borrowing a set amount, and then paying it back a short time later with interest. If you can’t pay the full loan amount, you can pay just the interest and renew the loan with the same terms as before. This, of course, will cost you more in interest.
There are two popular types of short-term loans:
Payday loans -- These are unsecured loans where you write the lender a postdated check for the amount you borrow plus any interest and other financing charges. The loan term usually lasts as long as a standard pay period of two weeks. Other names for these loans are:
- Payday advances
- Cash advance loans
Car title loans -- These are secured loans where you give the lender your car title when you borrow the money. If you don’t pay them back, the lender can repossess your car. The loan term usually lasts one month. Other names for these loans include:
- Title loans
- Pink slip loans
The dangers of short-term loans
When something seems too good to be true, there’s always a catch. In this case, the issue is sky-high interest rates. Payday loans have an average APR of 400%, and title loans aren’t that far behind.
The combination of extremely-high APRs and short loan terms often results in borrowers getting stuck in a vicious cycle of debt. Most borrowers need to renew their loans multiple times and end up paying more than twice the original loan amount in interest alone.
Let’s say that you get a car title loan for $1,000 with a 25% monthly interest charge. At the end of the month, you need to either pay off the full $1,250 or pay $250 to extend the loan. If you extend the loan, you’ll have to make the same choice next month.
Given how expensive short-term loans are, why bother with them in the first place? The most common reasons are speed, convenience, and the fact that they don’t require a credit check. No matter your credit score, you could walk into a payday or title lender and get money that day. The phrase “desperate times call for desperate measures” comes to mind.
While you’re unlikely to find other lenders offering same-day loans with no credit check, there are still much better borrowing options available. Here are two to check out:
- Applying for a personal loan-- Multiple lenders offer personal loans for applicants who have a limited or poor credit history. It may not be a same-day loan, but you could have the money in your bank account within a matter of days.
- Carrying a balance on your credit card-- If you have a credit card, carrying a balance on that would likely cost you less in interest than a short-term loan, because consumer protection laws limit credit card APRs.
Don’t overspend on a loan
It’s difficult to borrow money when you have bad or nonexistent credit, but short-term loans aren’t a smart solution. You won’t have long before you’ll need to come up with a payment, and it’s far too likely that you’ll end up renewing your loan month after month.
To avoid getting into this type of situation, it’s important to put money into a savings account until you have a solid emergency fund. If you ever do need fast cash, stick to personal loans with more reasonable interest rates.
The Motley Fool owns and recommends MasterCard and Visa, and recommends American Express. We’re firm believers in the Golden Rule. If we wouldn’t recommend an offer to a close family member, we wouldn’t recommend it on The Ascent either. Our number one goal is helping people find the best offers to improve their finances. That is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.