Why do short term loans have a high interest rate?

It’s understandable to think an APR of over 1000% is ludicrous and unaffordable, but maybe there’s more to it than meets the eye. When we think about percentages in mathematical terms, we know that 100% is the total, and so anything over 100% is more than the original value. Hence, 1000% appears to be 10 times the original value, and no one wants to pay 10 times the amount of their loan principal when it comes to borrowing money.

However, like a lot of financial terms, APR is often misunderstood which leads to a lot of confusion about why the APR on short term loans is so high.

Hopefully in this article, we can bust a few myths and shed a little light on just why there is often a higher interest rate on a short term loan compared to other loan products, and what the perceived high interest rate actually equates to in terms of monetary value.

Types of Credit

Short term loans are just one type of a broad range of credit products. More commonly, you might have heard of:

• Mortgages
• Personal bank loans
• Credit cards
• Overdrafts
• Credit Lines
• Buy now, pay later

All of the above can be listed under the umbrella ‘credit’ and although they are all very different, all of them are subject to an applied annual interest rate, usually noted as APR.

What is APR?

Annual percentage rate (APR) is the rate of interest which is charged for your borrowing over a whole year. It relies on a 12 month term and is a good way of comparing loans which have the same or very similar repayment schedules.

Why is the interest rate different for different credit products?

There are a lot of factors that contribute to an interest rate. Obviously, the loan needs to be affordable, but the interest rate applied by the lender often depends on the loan term (this is how long you borrow for) and the amount that you borrow.

Loan Term

The duration of your borrowing plays a big role when it comes to working out the interest rate for your loan. For example, a mortgage duration is typically 25 years, which means a mortgage lender has 25 years to recoup the costs of providing you with a mortgage. As this is a very long term, a mortgage lender can afford to charge a smaller interest rate as the total amount of interest that will accrue over that 25 year period will be quite significant.

Contrastingly, a personal bank loan usually has a loan term of maybe 3 to 5 years, and so the timeframe the bank has in order to make their money on your borrowing is much shorter, and so the interest rate tends to be a bit higher.

The Amount you Borrow

Similarly to loan term, the amount you borrow is also important when calculating an interest rate. As interest rates work in percentages, the more you borrow, the more you will repay in interest. For example:

10% of £100 is £10 but 10% of £500 is £50

Although the percentage value is the same, the cost in pounds is very different. Therefore, the more you borrow, the smaller the interest rate can be because it still provides a high yield in actual money. This is why a mortgage interest rate might only be 2.5% APR but the interest rate on car finance could be 25% APR. In monetary terms, the difference looks like this:

Although both will cost you £5,000, the interest rate is massively different.

Why is the interest rate on short term loans higher than on other loans?

Every business model must be sustainable if it intends to continue trading. For example, if a latte costs £1 to make, and a coffee shop charges £1 for that latte, they won’t make any profit which means they can’t pay the ground rent for their shop, they can’t pay their staff who made the latte and they can’t buy any more cups, coffee or milk to make any more lattes. So, while they didn’t lose any money on selling the latte for £1, they won’t be able to continue selling coffee if they don’t start to make a profit – even if it’s only by a small margin.

It’s the same principle for most businesses, and this includes short term loan providers. Short term loans are only for a very small amount compared to other credit products which is why a higher interest rate is necessary to recoup the costs of providing the loan. As explained above, the loan amount is much smaller and so a small interest rate will generate very little actual money. Although the interest rate on a short term loan is much higher than on a mortgage for example, the amount of interest you repay a mortgage lender is far greater than the amount you repay a short term loan creditor. Below, we delve into the individual factors that contribute to the interest rate applied to short term loans.

Assessing your Application

When you apply for a short term loan, the customer process is relatively straightforward: you fill out an application form and within a few minutes you have the outcome of that application. Loan applications are done like this to allow a customer a smooth application process – because having an emergency cashflow issue can be stressful, so you don’t need a difficult and uncooperative loan application to add to it.

However, behind the scenes, there’s a lot of work going on to assess your application to ensure the lender makes a responsible lending decision. Even creating and hosting a website in order to submit the application costs money.

Part of the assessment includes affordability and creditworthiness checks and these both cost money to conduct too. Every time a customer makes a loan application, the lender has to pay to check if the loan is affordable, even if the application is not approved.

Loan Term and Loan Amount

As with most credit products, other factors include the loan term and the loan amount. Short term loans generally have a loan term of between 1 and 6 months. This means that in some cases, the lender only has 1 month to recoup all the costs of providing the loan. Further to this, short term loans are only for a small amount of money, usually less than £1000 and on average, around £250 (FCA, 2019). This means the amount of money being lent is really small compared to mortgages or even car finance and so a small percentage rate will generate little to no income at all. Take the mortgage interest rate of 2.5% APR, for example. If you borrowed £250 for 1 year it would cost £6.25, but when you consider that the short term loan of £250 would only have been borrowed for 1 month, it costs much less - just 52p.

To help you understand how much a short term loan costs, despite the high APR, we’ve put a short example below:

The representative APR on our website for a £250 loan over 3 months is 1288% - and that sounds like a high percentage, but the fixed interest rate of 290% per annum means it actually only costs £1.99 per day, or £71.51 to borrow £250 for 3 months. This is a lot less than most people assume when they hear an APR in the thousands, which is why it’s important to understand how APR works on short term loans before writing them off as an unaffordable and irresponsible lending option.

When things go wrong

As well as providing the service to obtain a loan, lenders also have to have staff on hand to deal with any customer queries, and, less fortunately, to deal with any issues that occur when it comes to repaying the loan.

Unfortunately, not everything in life always goes according to plan and when it doesn’t, it can be a relief to know you are able to discuss your financial difficulties with your creditor and arrange a more affordable and sustainable solution. In the same way you need a barista to make your coffee, you need a call handler to answer your calls and assist you with your queries.

In conclusion

A business won’t be commercially viable if they don’t recoup the costs of running the business, which means they won’t be able to continue trading and offering their service. When it comes to loan providers, this means customers would be left without access to short term cash, and for some of those customers, that means financial exclusion from all avenues of credit.

While there might be cheaper borrowing options available, not all of those options are available to everyone, and some of them just aren’t suitable for every occasion. If you only need to borrow a small amount of money for a short period of time, then taking out a bank loan for a few thousand pounds might not be a sensible decision because although the interest rate might be smaller, the amount borrowed is much larger and so the total repayment could cost you more than if you borrowed the amount you actually needed from a short term loan lender.

Annual percentage rate is not the only factor you should consider when comparing and applying for loans. Use the loan calculators on lenders’ websites to find the actual amount your repayments will cost, and maybe compare the per annum interest rate, which is sometimes shown as “PA”, to see how much you’ll be charged daily.

Additionally, you should think about why you need the loan: could you actually save a bit of cash first rather than borrowing the money? How much you need to borrow: could you adjust your monthly budget to accommodate the expense? And think about if you can afford to repay the loan: do you have any upcoming payments due or has your overtime been reduced this month?

Ultimately, borrowing money from any lender will cost you money regardless of the interest rate (unless it’s 0%!), so borrowing always needs to be a considered and responsible decision. Not repaying your loan on time can cause serious money problems further down the line and make credit harder to obtain in the future.