A short-term loan is a type of loan that businesses obtain for temporary needs. Individuals can also get short-term loans to fund emergency expenses or expenses of temporary nature.
Short-term loans can be an easy way to finance activities or operations that will generate high returns. They can also be helpful when individuals or businesses have cash flow problems but expect inflows shortly.
Similarly, the entity acquiring the short-term loan can also benefit from the flexibility of payments that comes with short-term loans.
Short-term loans are a good option for small businesses or startups to obtain quick finance. Usually, that is because receiving short-term loans doesn’t require them to provide an asset as collateral.
Similarly, short-term loans can also be beneficial for individuals who have a bad credit rating or do not have any credit history. Overall, short-term loans are easier to obtain and, therefore, better suited to particular entities.
While short-term loans can be highly beneficial for entities, they also have some limitations for both businesses and individuals. These are listed below.
1) Higher interest rates
While short-term loans are easier to obtain, they also come with a higher interest rate as compared to long-term loans. It is one of the main limitations of short-term loans for entities.
As mentioned above, short-term loans are more suited to small size entities or individuals that do not have a credit rating or credit history. Some of these businesses may also not have the proper resources to meet the interest demands for short-term loans.
The reason short-term loans come with a higher interest rate is because of the risks involved with them. While short-term loans are less risky as compared to long-term loans because of the shorter duration, they still are risky.
The risks that financial institutions providing short-term loans must face is due to the high risk of default. It is because financial institutions provide these loans to entities that don’t have a credit history or satisfactory credit ratings.
Therefore, the risks associated with default increase significantly.
2) Higher instalment repayments
Short-term loans may come with a more flexible repayment schedule, but they also come with higher instalment repayment requirements.
It is mainly because short-term loans spread over a shorter amount of time as compared to long-term loans. Therefore, financial institutions will require their loans repaid quicker.
Higher installments can cause businesses to budget for these payments. It means that these installments can harm their budgets, especially for small size businesses or startups.
3) Early payment penalties
The main return for the financial institution providing short-term loans is the higher interest rates that borrowers have to pay. In case the borrower returns the loan earlier than the agreed-upon time, the lender loses the ability to profit off the short-term loan.
In these cases, the financial institution may impose conditions that disallow early repayment or discourage it. Sometimes, these conditions may also come in the form of penalties. The penalty will compensate the lender for the lost profits but may end up disadvantaging the borrower.
4) Limited finance
One of the other disadvantages of short-term loans is the limited finance entities receive. While short-term loans are a great way to fund temporary cash needs, entities cannot use them for any big projects.
The finance provided through short-term loans are significantly lower as compared to long-term finance. If borrowers are looking for a type of finance to fund large projects, they may have to look into other types of loans as opposed to short-term loans.
5) Force entities into borrowing loop
Short-term loans are readily available for every type of entity to obtain, regardless of whether they can repay the loan or not. There are no checks that financial institutions make before giving out short-term loans.
That means some entities that may not have the ability to repay loans may also get loans. For those entities, short-term loans can force them into a borrowing loop.
It means when they can’t repay the loan, they will obtain more loan to pay the previous loan and so on.
6) Negative impact on credit score
This disadvantage of short-term loans is related to the ability of the borrower to repay the loan. As mentioned above, short-term loans come with higher costs and higher instalments, which can affect the ability of the borrower to repay the loan.
Therefore, it can end up harming the credit score of the borrower instead of improving it. It also affects some main ratios of a business, which can deter its ability to attract investments or obtain more loan.
Short-term loans are loans used to finance temporary activities. Short-term loans can have some benefits such as better flexibility or easier obtainability, but they may also come with some disadvantages.
The main disadvantages of short-term loans are that they require higher interest payment and higher instalment repayments.
They may come with early payment penalties as well, and only provide limited finance, as compared to long-term loans. Likewise, they may force entities into a borrowing loop and negatively affect their credit score in case of default.