Short Term Loan Definition
Short-term loans are defined as borrowings undertaken for a short period to meet immediate monetary requirements. For example, companies often borrow short-term loans using bank overdrafts to arrange money for working capital requirements.
The loan tenure varies based on the debt type. For example, many loans mature in 6-12 months, while others come with a tenure of 1-2 years. The interest rate on inter-bank overnight loans is an essential tool with which central banks control inflation or deflationDeflationDeflation is a decrease in the prices of goods and services caused by negative inflation (below 0%). It usually results in increased consumer purchasing power, owing to a simple supply and demand rule in which excess supply leads to lower prices..
- A short-term loan is a credit facility extended to individuals and entities to finance a shortage of cash. Examples include credit card, bank overdraft, trade creditTrade CreditThe term "trade credit" refers to credit provided by a supplier to a buyer of goods or services. This makes it is possible to buy goods or services from a supplier on credit rather than paying cash up front., payday loans, etc.
- The loan tenure varies based on the debt type. Many loans mature in 6-12 months while others come with a tenure of 1-2 years.
- The annual percentage rates (APRs) or the interest rates are normally set high. Short tenure restricts lenders from making adequate profits which is why they try to compensate it with higher interests.
- Most short-term loans are unsecured as there is no property that can be sold off for recovery if the debtor defaults. As such, loan applicants with a good credit score are preferred.
- Low credit score applicants often have to struggle quite a bit to secure a short-term loan. They are often extended loans at very high interest rates.
How Does a Short-Term Loan Work?
A short-term loan works as a rescue when people need some money urgently. For example, a business cannot finance its daily orders if all its debtorsDebtorsA debtor is a person or entity that owes money to the other party in a transaction. The receiver is referred to as the creditor, and the payment terms vary for each transaction based on the terms and conditions agreed upon by the parties. are delaying payments. Banks, credit unions and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. provide many short-term lending facilities to businesses to cover their everyday costs.
These loans come in different shapes and sizes. One can get a short-term loan from banks, financial institutions, and suppliers. Borrowers can apply for short-term loans online or by visiting a branch. The lender checks the loan applicant’s creditworthiness, discusses the terms, fulfills paperwork and releases the money once approved.
Features of Short Term Loan
- The annual percentage rate (APR) or the interest rates are normally set high as a short tenure restricts lenders from making adequate profits. Normally, the tenure is less than a year and in some cases 1-2 years, leading to less accrued interestAccrued InterestAccrued interest formula calculates the interest earned or payable on the debt over one accounting period. Formula = loan amount * (yearly interest/365) * time period.. Lenders rake in higher earnings with long term debtsLong Term DebtsLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability. as repayments usually last for many years, piling up the interest amount.
- Moreover, lenders charge a high interest rate to compensate for the possible default loss as these loans are mostly unsecured. An unsecured loan is not backed with any collateral and so there no property that can be sold off for recovery if the debtor defaults.
- Since many lenders are not asking for collateral, they require borrowers to have a good credit score to ensure their creditworthiness for timely repayments.
- Also, the borrowing amount is usually small as compared to other forms of loans.
- Both the principal as well as the interest need to be repaid in full within the term of the loan. Many have a weekly repayment schedule.
- Many borrowers prefer short-term loans from a direct lender that eliminates any intermediaries such as credit brokers. A delay on the part of the broker could delay an applicant’s loan. In addition, direct lending for short-term loans often come with online facilities, faster approval and loan sanction. As a result, Covid-19 saw heavy demand for direct lenders.
Types of Short-Term Loans
Let us discuss some of the types in detail.
#1 – Line of Credit (LOC)
A line of credit Line Of CreditA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business. is a kind of loan wherein a bank or financial institution sets a maximum loan amount that an individual is allowed to borrow. The borrower has the flexibility to withdraw the loan amount in a lump sum or instalments. Borrowers cannot withdraw beyond the permitted limit, which is determined based on their creditworthiness.
In return, the bank charges only on the withdrawn amount and not the remaining available balance of the loan. When it’s the time to pay the dues, the borrower will not be able to withdraw until the due principal and interests are paid. After paying the dues, the borrower can resume using the line of credit service. LOC works best when one requires a regular supply of credit.
#2 – Short-Term Bank Loans
Unlike a LOC, loans terminate at the end of a fixed tenure. Therefore, if the borrower wishes to borrow once again, they may have to apply for a fresh loan. An example is a personal loan to finance a wedding.
#3 – Bank Overdraft
A bank overdraft is one of the most common types of credit facilityCredit FacilityCredit Facility is a pre-approved bank loan facility to businesses allowing them to borrow the capital amount as & when needed for their long-term/short-term requirements without having to re-apply for a loan each time. . Under this service, if bank account holders have insufficient money in their account than the amount they are trying to withdraw, the bank will provide the rest. In return, the bank charges interest with some setting exorbitant rates.
Businesses have innumerable transactions every day, leading to a fast-falling bank balance. A bank overdraft service avoids operational interruption due to rejected payments on account of a low balance. However, customers need to exercise caution when using bank overdrafts. Some reputed providers have charged unaccrued interests from their customers. Often, these banks have paid millions in fines for such illegalities.
#4 – Merchant Cash Advances
They are suited to businesses with large credit card/debit card sales instead of cash sales, i.e., their customers make card payments during purchases. Under this facility, a financial institution agrees to advance a lump sum amount to the borrower. The lender subsequently recovers this amount as a percentage of the borrower’s daily sales.
#5 – Invoice Financing (Receivables Financing)
Under this facility, a company borrows money from a bank or financial institution against the money due from its customers, i.e., account receivablesAccount ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.. When customers take time to pay bills, a company can borrow in the meantime to meet its liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. requirements. Lenders charge a fee for invoice financingInvoice FinancingInvoice Financing is way to obtain funds for short term liquidity needs of a company by keeping account receivables as a collateral. These funds are usually utilized to pay off the short term liabilities like salaries, creditors etc., which they deduct from the lent sum. Receivables can be used as collateral, so if the borrower defaults, the bank can rely on them.
#6 – Payday Loans
With payday loans, the borrowing amount is determined based on the borrowers’ earnings, mostly as a specific percentage of their income. Repayment is to be made upon the receipt of the next paycheck/income. Payday loans come with unreasonably high interest rates and can be acquired either online or from stores.
- Avenue for Small Loans: People don’t necessarily have to take a mortgage loan when they are in need of some immediate cash. A short-term credit facility allows people to arrange a small amount of money from financial institutions for needs such as medical emergency, or business expenses.
- Faster Approval: Short-term loan do not require lengthy approval processes as compared to other forms of loans.
- Lower Accrued Interest: As the repayment period is shorter, the amount of interest paid by the borrower is lower.
- Increases Credit Score: Availing such a loan and paying it off without any default can help increase the creditworthiness of the borrower.
- Unsecured: Such loans are usually unsecured, and borrowers do not require any collateral, making it easier to acquire funds at a short notice.
- Economic Well-Being: The interest rates on inter-bank overnight borrowings is an essential tool with which central banks control inflation or deflation. This is because an increase or decrease in short-term lending rates eventually affects the borrowing cost of kinds of all loans. When a central bank intends to increase growth, it lowers interest rates, increasing investment and consumption, leading to higher GDP, wages, and employment.
- Lower Borrowing Amount: Sometimes, the borrower may require a larger amount which cannot be availed under short-term credit.
- Small-time Borrowers Plight: Several payday loans charge up to 400% interest in a year. High APRs make it difficult to manage repayments for those with humble means. Any interest rate hike or penalties may cause a further strain which may result in default and subsequent lower credit score.
- Unfair Means: Over the years, many payday and credit card lenders have made headlines for harassing their debtors. As per a 2020 study, over 3000 borrowers were issued an arrest warrant over payday loans, vehicle title, and other expensive lending.
- Credit Score: Due to unsecured nature of the loans, those with low credit score often struggle to acquire funds from reputed sources. With years many short-term loan providers have surfaced who provide loans to those with a bad credit score. They charge heavy interest rates to compensate for the lack of creditworthiness. With more expensive loans, the chances of default increase which can further damage the credit score.
People don’t necessarily have to take a mortgage loan when they have an immediate need for some cash. A short-term loan allows people to arrange a small amount of money from financial institutions for needs such as medical emergencies or business expenses. The loan amount is small, and maturity is usually a year long.
An example of a short-term loan is a bank’s overdraft facility. Under this scheme, if the borrower’s account holds insufficient funds to make a payment, the bank extends additional funds. In return, the bank charges the borrower for the service.
There are many avenues to get a loan in a short time, one being many banks providing an online facility to apply for the loans. If approved, some personal loan providers can lend money within 24 hours. In addition, some institutions provide attractive rates to those with a high credit score.
This article has been a guide to what is Short Term Loans are and their 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 –