In this article:
- What is a short term or payday loan?
- Will the process of applying for a short term loan change my credit score?
- Are there any positive impacts that short term loans can have on a credit score?
- Are there any negative impacts that I should be aware of?
What is a short term loan?
Unlike a traditional personal loan, which would typically be paid back over several years, a short term loan is generally defined as one that is scheduled to be repaid over a period of less than a year. Other than that, the structure of the loan agreement is likely to be more or less the same as that you would expect from a longer-term loan.
Due to the relatively short repayment period, it is likely that interest rates will be high, certainly compared to that of long term loans, or mortgage agreements. The penalties for failing to make the loan repayments may also be more severe than longer-term loan agreements.
Short term loans are commonly associated with online companies and businesses which may be referred to as ‘payday loan providers’. These extremely short term loans are designed to be repaid in just a few weeks or months, hence the implication of the name that they are specifically intended to cover a cash shortfall up until ‘payday’.
Although more typically associated with online providers, some high street banks do now offer short term loans as well. These agreements may be for a set period of months, or up to a year.
Will the process of applying for a short term loan change my credit score?
As with any loan, a short term loan will show up on your credit report. However, it is not just the loan itself – it is worth bearing in mind that any application you make for a loan can show up on your credit report too, and this in itself can impact upon your credit score.
If, for example, you made full applications for short term loans to lots of lenders in a short space of time, each of these lenders will have made credit checks against you. These credit checks are recorded on your credit report and can reduce your credit score – specifically if there are a number of credit checks which appear on your report in a short space of time. This is because the occurrence of multiple checks imply that you made multiple applications to different lenders, which is likely to be a red flag for any future lenders, as it raises questions about your financial stability.
Rest assured that you can still ‘shop around’ for short term loans – many lenders will be able to run a ‘soft search’ against your record when you make an enquiry to them. This gives them some top-level details from your credit report and is normally enough for them to give you an indication of whether they would be willing to offer you a loan.
This kind of ‘soft search’ does not leave any trace on your credit report, and so doesn’t have any impact on your credit score. Bear this in mind when you are considering which short term loan is best for you – and make sure you know when a lender is going to formally run a full credit check against you.
Are there any positive impacts that short term loans can have on a credit score?
One of the things that credit reports are put in place for is to help potential lenders assess whether you reliably make all the payments due on your debts. In that sense, there can be some benefits that come from taking out a short term loan, as long as you repay it effectively.
If you reliably pay back your short-term loan in accordance with the terms of your loan agreement, this will be reflected on your credit report. This can have a positive impact, as it is an indication that you take your debts seriously, and do not default on payments. It is likely to raise your credit score, at least a little.
Are there any negative impacts that I should be aware of?
Again, as with any debt, if you miss a payment, this will show up on your credit report and will have an adverse effect on your credit score. This is likely to be a red flag to future lenders, especially mortgage providers, who will see it as a sign that you may not be able to pay back a loan they give you.
It is especially critical to note that short term loans can have a very high-interest rate. This is often significantly higher than longer-term loans. The relatively short repayment duration means that lenders use higher interest rates as a way to profit from the loan, quickly. This is particularly the case for payday lenders or other organisations who are willing to provide loans to people who have a poor credit history.
These companies tend to get away with charging higher interest rates because they know that customers with a poor credit history have fewer options when looking for a loan. It’s also a risk-assessment based approach – the company knows that if it lends to a high number of people who have a poor credit history, they are likely to experience a higher rate of default than credit providers who only lend to customers with excellent credit ratings.
What this means in practice is that, if you do end up missing a payment, the high-interest rates – and any accompanying charges and penalties – may lead the debt to quickly spiral out of control. This kind of financial difficulty is likely to have a serious negative impact on your credit score, as your debts will be carefully tracked on your credit report. If you are in any doubt as to whether you will be able to make the repayments on a short term loan, it is advisable to carefully consider what other options are available to you. A longer-term loan may cost you more in interest over the lifespan of the loan, however, if the payments are more manageable, and you can reliably repay them, overall this may have a more positive impact on your credit score.