Short-term loans are cash advances issued by lenders to borrowers who need immediate financial assistance. To provide borrowers with quick, upfront cash, these lenders typically impose high-interest rates to cover their services and protect against potential default.
Typically, short-term unsecured loans in the UK will be for relatively smaller amounts, and borrowers will be able to, for example, borrow £100 or get a £1000 loan online from various short-term lenders, online or on the high street.
Several other factors can influence and affect the interest rate of any loan. Below we offer some reasons why short-term loans have such high-interest rates.
What Is a Short-Term Loan?
Financial emergencies can occur at any time. And many people don’t have sufficient funds on hand when they suddenly need to pay an unexpected medical bill or repair their cars. Short-term loans are typically suitable for these types of events.
High-interest, short-term loans can be an option for people facing financial emergencies. However, before opting for one, you should be aware of government regulations. The amount you can borrow usually ranges from £100 to £1,500 loans and sometimes even a little more.
The interest rate depends on the amount you borrow, but according to the Financial Conduct Authority (FCA ), the average APR for short-term loans is 1,250%. This is one of the reasons why short-term loans of this nature are intended for financial emergencies and when there is no alternative, for example, if you need to pay off a credit card bill that is pressing or purchase groceries for your family.
What Is APR?
APR represents the annual percentage rate and is the yearly interest rate charged on loans. A 1,250% APR might look intimidating. But if you break it down to a daily rate, things may start making more sense.
For example, the APR for a £250 short-term, three-month loan may be 1,177%. But the UK has capped short-term loan rates at double the amount borrowed. So, in any case, a lender cannot charge more than £500 for a £250 loan, or in the case of a £200 loan, they cannot charge more than £400.
As you can see, an APR of more than 100% doesn’t mean you have to pay ten times more interest than the loan amount. But still, it’s pretty high compared to most other loan types like a mortgage or student loans.
Why Do Short-Term Loans Have Higher Interest Rates?
A lender provides services to the borrower in the form of short-term loans. Most importantly, these loans give applicants access to fast cash. To continue providing fast services, lenders charge high-interest rates to reimburse for their services and protect their business from potential defaults.
Another factor that contributes to the high-interest rate of short-term loans is the accelerated application review process. Therefore, the costs of assessing the applicant’s information, making a decision, hiring staff, and running a website for online applications can be pretty high.
As a result, the lender needs to charge higher interest rates to recoup these expenses. When applying for short-term loans, you should therefore factor into your budgeting that your repayment will have higher than average levels of APR attached.
Lastly, short-term loans generally have high default risks because of their quick repayment terms. As a result, some borrowers are unable to pay back their loans on time or in full. As a result, to protect against these instances, lenders also institute high-interest rates.
How to Calculate Short-Term Loan Interest
Calculating short-term loan interest follows a simple formula. If you know the APR, you can calculate the total interest by dividing the APR by 100%, multiplying it by the loan term, dividing it by 365 days, and multiplying it by the loan amount.
For instance, if you take a £300 loan with an APR of 400% for 14 days, the total interest due would be:
400 / 100 x 14 / 365 x 300 = £46
This means that taking a £300 loan and repaying it in two weeks would cost you £46 in interest fees.
Does a Change in Interest Rates Affect Short-Term Loans?
Several factors can influence interest rates for short-term loans. The Bank Rate is the national interest rate. The Bank of England, supervised by the Monetary Policy Committee (MPC), usually increases or decreases the Bank Rate to protect against market volatility caused by supply and demand or inflation. These changes eventually cause interest rates on short-term loans to shift too.
The government usually raises interest rates when the economy is doing well to prevent inflation.
Conversely, it lowers the interest rate to promote growth in times of economic decline. As a result, in addition to lenders contributing to high-interest rates, economic conditions also cause short-term interest rates to increase, including among lenders you may apply for a loan with when you need to borrow money online in the UK.
At the end of the day, short-term interest rate fluctuations are a normal phenomenon and occur occasionally. You should always check whether your loan’s rate is fixed or variable before applying. If you have a fixed loan rate, any changes in interest rates won’t probably affect you.
What to Use Instead of APR to Calculate Loan Costs?
Using the annual percentage rate to compare loan costs may be misleading. Many people get confused when they see three- or four-digit interest rates when in reality, other calculation methods can show a clearer picture.
One way to compare loan costs is the per annum (or p.a.) interest rate. The UK government has capped short-term interest rates at a maximum of 0.8% daily, or 292% per year. If you want to know the total loan cost, you can multiply it by the number of days you’re looking to borrow. So, for example, it may cost you £1.6 daily to borrow £200.
UK lenders usually display representative examples on their websites that give borrowers an idea of how much it would cost to borrow their loan products. Additionally, most lending websites provide online calculators that let you know how much interest you will have to pay to borrow money in the UK. You can insert the loan term and amount and see the total interest before applying for a loan.
Conclusion
Short-term loans may be an option for those in sudden need of money. However, lenders usually charge high-interest rates on these loans in order to recoup the costs and associated risks of lending.
Before applying for a short-term loan, make sure to go over your budget and the loan conditions carefully to see if you can repay it on time. Note that failure to make repayments on time can result in a negative impact on your credit score. If you are unsure whether you can make the payments on time, there may be alternatives to short-term loans. For instance, you may opt to borrow from family or friends, and you can even apply for government assistance programs.
