What Are Short-Term Loans? How They Work

What are Short-Term Loans and How Do They Work?

Lauren Ward

Updated December 22, 2021

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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

Short-term loans are a type of financial product that some borrowers may be able to qualify for with or without great credit. They can be appealing to borrowers because lenders are usually able to process the loan application and distribute the loan proceeds quickly. When time is of the essence, potential borrowers might consider a short-term loan. There are drawbacks to short-term loans, of course, such as high interest rates and short repayment periods. However, as long as borrowers understand the terms, short-term loans can be a convenient solution to many financial problems.

What Is a Short-Term Loan?

The term of a short-term loan is typically defined as one year or less. Some short-term loans are unsecured, which means they do not require the borrower to put up any collateral. Secured loans, however, require the borrower to put up an asset they own to secure the loan. To qualify for a short-term loan, borrowers must provide proof of income as well as a government issued ID. Sometimes that’s all that is needed, but it depends on the lender and the type of short-term loan being applied for. To get an unsecured short-term loan with a favorable interest rate, an applicant will typically need to have a good credit score and positive credit history. However, there are short-term loans on the market that are tailored exclusively for low-credit borrowers.

Types of Short-Term Loans

There are a few types of short-term loans borrowers can choose. These include:

Bank Overdraft

While a bank overdraft is technically a short-term loan, it’s not one borrowers often choose. Bank overdraft loans are initiated when a borrower overdraws from their bank account and covers the costs of any expenses the account holder incurs on the account. Banks sometimes charge fees and interest on bank overdraft charges.

Car Title Loan

Title loans use the borrower’s car as collateral to secure the loan, assuming the borrower owns it outright and has clear title. During the term of the loan, the lender keeps the vehicle’s title. If the borrower does not repay the loan according to its terms, the lender can take ownership of the vehicle.

Invoice Financing

Sometimes used by small business owners, invoice financing allows a borrower to access funds against unpaid invoices. The lender charges a percentage of the invoice amounts as a fee. Borrowers are expected to pay back the lender after they have received payment.

Lines of Credit

Similar to a credit card, a personal line of credit (LOC) allows borrowers to access funds on a revolving basis. There are two periods, a draw period and a repayment period. The draw period of an LOC is a fixed amount of time during which money can be borrowed and repaid, up to the loan limit. The repayment period begins after the draw period ends. Some lenders may require a balloon payment and others may structure the payments over time.

Merchant Cash Advance

Some businesses may use a merchant cash advance that allows them to borrow a lump sum against future credit card sales. Interest rates and fees on merchant cash advances can be high, making it difficult to repay this type of debt without refinancing.

Payday Loan

A payday loan provides a borrower with needed cash until they get their next paycheck. While they provide borrowers with quick access to funds, the interest rates and fees can create an endless cycle of debt for borrowers.

Working Capital Loan

Companies that need help financing the costs of day-to-day business affairs may opt to use a working capital loan. These loans are not used to purchase long-term investments, but are simply used to cover the costs of everyday operations, such as inventory purchases.

Are All Personal Loans Short-Term Loans?

It’s actually the other way around: Short-term loans, instead, are a type of personal loan. While personal loans often come with a repayment period of five years or less, short-term loans require payment in full even sooner than that — some just a few weeks after distribution.

What Are Short-Term Loans Typically Used For?

Short-term personal loans are used for a variety of expenses. Sometimes they’re used to cover an unexpected expense, such as a car repair or medical bill. Other uses for short-term loans are living expenses, home maintenance, and appliance repair or replacement.Short-term loans aren’t used just by individual borrowers. Short-term business loans are frequently used by businesses to cover expenses until further income or revenue is received from clients and customers.

Factors That Lenders Consider in Determining Short-Term Loan Application Approval

Different lenders may assess loan applications differently, but typically look at the following criteria:

Credit score
Credit report
Monthly or yearly income
Debt-to-income ratio (DTI)
Employment history
Value of collateral (if needed)

Advantages and Disadvantages of Taking Out Short-Term Loans

Short-term loans can be a good choice for some borrowers and some financial situations. But there are also important potentially negative aspects of a short-term loan to consider.

Advantages of a Short-Term Loan

Easy to qualify for: Compared to long-term loans, it can be easier to qualify for a short-term loan than a long-term loan. While there are eligibility requirements each borrower must meet, these requirements are sometimes more relaxed because the lender will make a profit through fees and interest.

Fast funding period: After you have applied and been approved, it’s not uncommon to receive funds within a few business days or less (sometimes even the same day).

Disadvantages of a Short-Term Loan

Short repayment period: Borrowers don’t have long to pay back borrowed funds. Repayment periods can be as little as a few months or even weeks. This can sometimes create an ongoing cycle of debt.

More expensive than a long-term loan: With a long-term loan, a shorter repayment period would usually mean lower interest rates. However, because of the easy qualification process, interest rates remain high with short-term loans, making them more expensive than long-term loans in most cases.

Smaller loan amounts for most borrowers: Most borrowers seeking a short-term loan will not be able to borrow as much as they would with a long-term loan. Businesses with excellent credit may be able to make frequent use of short-term loans at increased borrowing amounts and lower interest rates.

What Are Some Alternatives to Short-Term Loans?

Short-term loans are just one of many financial products available to borrowers. Some others to consider are:

Promotional Periods on Credit Cards

Credit cards with promotional periods of low or 0% introductory APRs give qualifying card holders access to a revolving line of credit that charges low or zero interest for a set amount of time. Many promotional credit cards offer this sign-up bonus for around 18 to 24 months.

Home Equity Loan or Line of Credit

Borrowers who have built up some equity in their homes may consider using a home equity loan or a home equity line of credit (HELOC) instead of a short-term loan. The main difference between the two is how the funds are distributed. A home equity loan’s funds are distributed as a lump sum. A HELOC is revolving credit (with a credit limit) that is distributed as the borrower needs the funds, not usually all at one time.

Asking Friends or Family

Borrowing money from family or friends is a possibility, but can come with some caveats. It’s important to make the repayment terms clear so each party understands their role, limiting any damage to the relationship.

Personal Loan

A more traditional personal loan can be an option, too. The applicant’s credit will likely determine approval. Rates and terms with personal loans are often more favorable than most short-term loans.

The Takeaway

At Lantern Credit, you can easily shop for and compare personal loan rates online. Having access to multiple lenders streamlines the rate-shopping experience to make it as easy as possible. You only have to submit one application to receive multiple estimates. If you’re considering a personal loan, Lantern by SoFi can help narrow your lender choices so you can apply for the loan and have the money when you need it.Check your rate on a personal loan from Lantern by SoFi.

Photo credit: iStock/sturtiSoFi Loan Products SoFi loans are originated by SoFi Lending Corp (dba SoFi), a lender licensed by the Department of Business Oversight under the California Financing Law, license # 6054612; NMLS # 1121636. For additional product-specific legal and licensing information, see SoFi.com/legal.SOLC112221

About the Author

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.

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