What is a Short Term Loan?
Short term loans are borrowings that have a repayment period of 12 months or less and are usually availed by businesses/entrepreneurs/individuals to meet their immediate liquidity requirements.
Typically, short term loans have the following features –
- Lower Borrowing Amount – The borrowing amount is usually lesser as compared to other forms of loans.
- Higher Annual Percentage Rate (APR) – These kinds of loans carry a higher interest rate.
- Unsecured – These loans are mostly unsecured in nature. Considering that the borrowing amount, as well as the repayment period, is less, the necessity to have collateral also decreases.
- Repayment – Both the principal as well as the interest need to be repaid in full within the term of the loan. Short term loans usually have a weekly repayment schedule.
Top 6 Types of Short Term Loans (with examples)
Below are the different types of short term loans with examples.
#1 – Line of Credit (LOC)
A line of credit is a financing arrangement wherein a bank or a financial institution determines in advance, the maximum loan amount for a particular borrower based mainly on their creditworthiness. For example, Ashley, who has a high credit score, may be eligible to borrow $10,000 whereas Ellen, who has a lower credit score, may only be eligible to $5000.
- The loan amount may be withdrawn by the borrower in a lump sum manner or alternatively in installments, as the need arises. Charges are incurred only for the amounts borrowed and not for the sanctioned loan amount.
- Once the borrowed amount is repaid in full, the borrower is eligible to a fresh line of credit with the same predetermined loan amount. This is referred to as a revolving credit facility i.e there is no fixed tenure for the facility until such time that either party chooses to close the LOC.
- The interest rates under this facility tend to be fixed for the entire period of LOC and are subject to hikes only in the event of any default or late payments.
#2 – Short Term Bank Loans
A short term bank loan terminates at the end of fixed tenure, unlike a LOC which may be renewed after the repayment of the debt. If the borrower wishes to borrow once again, he/she may have to apply for a fresh loan.
#3 – Bank Overdraft
Bank overdraft facility is a type of line of credit which is linked to the existing bank account of the borrower. The amount of overdraft is fixed by the bank in advance. In the event that the funds in the borrower’s account are insufficient to cover any payments to be made, the bank extends additional funds. Bank charges are to be paid for such facilities.
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This facility can be explained best with an example of a company. Companies have a huge number of transactions on a daily basis. There could be a scenario wherein payments are to be made urgently but there are insufficient funds in the bank account. To provide for such eventualities, the company avails the overdraft facility to ensure that payments are made on time.
#4 – Merchant Cash Advances
This type of facility is most suited to businesses that have large credit card/debit card sales as opposed to cash sales i.e their customers make card payments during purchases. Under this facility, a bank/financial institution agrees to advance a lump sum amount to the borrower. This amount is subsequently recovered by the bank/financial institution, as a percentage of the daily sales of the borrower. For example, when the borrower makes a sale, a specified percentage of the sales, say 5%, shall be directly recovered by the bank from the payment facilitator such as PayPal or Visa.
#5 – Invoice Financing (Receivables Financing)
Under this facility of receivables financing, a company borrows money against the amounts due from its customers i.e receivables. This could be explained better with an example – A company has a large number of customers from whom payments are due. These customers usually take 30-45 days to make payments. There could be cases where there are late payments as well. In order to meet the immediate liquidity requirements of a company, it opts to go for invoice financing. The financial institution pays money to the company, after deducting a certain percentage of the invoices for its fee.
#6 – Payday Loans
This type of facility is most suited to individual borrowers or small-time businesses. Under this facility, the loan amount is determined based on the earnings of the borrower, mostly as a specific percentage of the income of the borrower. Repayment is to be made upon the receipt of the next paycheck/income.
Advantages of Short Term Loans
The following are some of the advantages of short term loans –
- Faster Approval: Short term loans do not require lengthy approval processes as compared to other forms of loans.
- More Accessible: Short term loans ensure that funds are accessible even to small-time businesses/ individuals.
- Lower Interest Costs: As the repayment period is shorter, the amount of interest paid by the borrower is lower.
- Increases Credit Score: Availing a short term loan and paying it off without any default can help increase the creditworthiness of the borrower.
- UnSecured: Short term loans are usually unsecured and borrowers do not require any collateral to avail these loans.
Disadvantages of Short Term Loans
Although short term loans have many advantages, there are also the following disadvantages –
- Lower borrowing Amount: Sometimes, the borrower may require a larger amount which cannot be availed through short term loans.
- The strain on Small-time borrowers: Any interest rate hike or penalties may cause strain on small-time borrowers, which may result in default and subsequent lower credit score.
- Not Suitable for Long term projects: Availing a short term loan for a long term project may result in high-interest costs.
Short term loans are ideally meant to cater to the immediate liquidity requirements of the borrowers. It is up to the borrower to evaluate and choose the method of financing best suited to the business so as to enjoy maximum facilities at a minimal cost.
This has been a guide to what is Short Term Loans and its definition. Here we discuss the Top 6 types of short-term loans including Credit Line, Bank Over Draft, PayDay Loans, etc. along with examples, benefits, and disadvantages. You can learn more about accounting from the following articles –