What is a Short Term Loan?
A short term loan is a type of loan that is obtained to support a temporary personal or business capital need. As it is a type of credit, it involves repaying the principle amount with interest by a given due date, which is usually within a year from getting the loan.
A short term loan is a valuable option, especially for small businesses or start-ups that are not yet eligible for a credit line from a bank. The loan involves lower borrowed amounts, which may range from $100 to as much as $100,000. Short term loans are suitable not only for businesses but also for individuals who find themselves with a temporary, sudden cash flow issue.
Characteristics of Short Term Loans
Short term loans are called such because of how quickly the loan needs to be paid off. In most cases, it must be paid off within six months to a year – at most, 18 months. Any longer loan term than that is considered a medium term or long term loan.
Long term loans can last from just over a year to 25 years. Some short term loans don’t specify a payment schedule or a specific due date. They simply allow the borrower to pay back the loan at their own pace.
Types of Short Term Loans
Short term loans come in various forms, as listed below:
1. Merchant cash advances
This type of short term loan is actually a cash advance but one that still operates like a loan. The lender loans the amount needed by the borrower. The borrower makes the loan payments by allowing the lender to access the borrower’s credit facility. Each time a purchase by a customer of the borrower is made, a certain percentage of the proceeds is taken by the lender until the loan is repaid.
2. Lines of credit
A line of credit is much like using a business credit card. A credit limit is set and the business is able to tap into the line of credit as needed. It makes monthly installment payments against whatever amount has been borrowed.
Therefore, monthly payments due vary in accordance with how much of the line of credit has been accessed. One advantage of lines of credit over business credit cards is that the former typically charge a lower Annual Percentage Rate (APR).
3. Payday loans
Payday loans are emergency short term loans that are relatively easy to obtain. Even high street lenders offer them. The drawback is that the entire loan amount, plus interest, must be paid in one lump sum when the borrower’s payday arrives.
Repayments are typically done by the lender taking out the amount from the borrower’s bank account, using the continuous payment authority. Payday loans typically carry very high interest rates.
4. Online or Installment loans
It is also relatively easy to get a short term loan where everything is done online – from application to approval. Within minutes from getting the loan approval, the money is wired to the borrower’s bank account.
5. Invoice financing
This type of loan is done by using a business’ accounts receivables – invoices that are, as yet, unpaid by customers. The lender loans the money and charges interest based on the number of weeks that invoices remain outstanding. When an invoice gets paid, the lender will interrupt the payment of the invoice and take the interest charged on the loan before returning to the borrower what is due to the business.
Advantages of Short Term Loans
There are many advantages for the borrower in taking out a loan for only a brief period of time, including the following:
1. Shorter time for incurring interest
As short term loans need to be paid off within about a year, there are lower total interest payments. Compared to long term loans, the amount of interest paid is significantly less.
2. Quick funding time
These loans are considered less risky compared to long term loans because of a shorter maturity date. The borrower’s ability to repay a loan is less likely to change significantly over a short frame of time. Thus, the time it takes for a lender underwriting to process the loan is shorter. Thus, the borrower can obtain the needed funds more quickly.
3. Easier to acquire
Short term loans are the lifesavers of smaller businesses or individuals who suffer from less than stellar credit scores. The requirements for such loans are generally easier to meet, in part because such loans are usually for relatively small amounts, as compared to the amount of money usually borrowed on a long term basis.
The main disadvantage of short term loans is that they provide only smaller loan amounts. As the loans are returned or paid off sooner, they usually involve small amounts, so that the borrower won’t be burdened with large monthly payments.
Short term loans are very useful for both businesses and individuals. For businesses, they may offer a good way to resolve sudden cash flow issues. For individuals, such loans are an effective source of emergency funds.
CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)® certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below: