Why do short term loans have a high interest rate?

With so many ways to borrow, choosing a credit facility to suit your cashflow needs can be tricky. Plus, with different interest rates and fees and charges, it can get all too complicated trying to compare different types of credit. When it comes to payday loan companies, however, there are fairly strict regulations on how the charges must be represented, but this can sometimes result in even more confusion and misconceptions over the costs of this type of borrowing.

What is a short term loan?

A short term loan is a fixed term loan that you can borrow for up to twelve months. Usually, the repayments are spread over the loan term in monthly instalments. Short term loans are generally available online, so anyone can apply at any time of day, and they tend to have higher acceptance rates for people with a poor credit history than other types of mainstream credit like credit cards and personal bank loans. Short term credit lenders typically offer loans anywhere between £100 and £1500, though depending on the type of lender, these amounts may vary.

What is high cost short term credit?

High cost short term credit, or HCSTC for short, is the official term for any credit offered for less than 12 months, with an APR of over 100%. Payday loans tend to be the most commonly recognised type of HCSTC, though there are various ways to borrow in this category.

Is high cost credit expensive?

High cost credit, as the term suggests, is higher in cost than other types of borrowing, but this doesn’t always mean it’s the most expensive option and can still work out cheaper if you only need to borrow a small amount of cash for a short period of time. Plus, for some people who are financially excluded from mainstream borrowing options, HCSTC might be the only option when money is temporarily tight.

Why do lenders charge high interest rates on short term loans?

You’ll probably see that even the best UK payday loans have representative APR rates over 1000%, and this can be a very scary figure and one that many find off-putting when looking for credit. While payday loan lenders have to publish the APR, it can often be more helpful to look at the daily interest rate or use an online loan calculator to see exactly how much a loan would cost.

Part of the reason HCSTC lenders charge an APR over 1000% is because the loan is borrowed for a very short period of time, and the monthly instalments mean that you repay part of the loan principal each time you make a repayment and so there is an increasingly smaller value for the interest to accrue on. Plus, short term loans tend to be for much smaller amounts than other kinds of credit.

It's also worth remembering that there is a total cost cap of 100% of the amount borrowed for this type of credit, so you’ll never repay more in interest, fees and charges than the loan principal.

Short loan terms

Short loan terms mean lenders need to charge a higher interest rate in order to generate enough income to cover the costs of providing their service because the loan can only accrue interest over a brief period. For example, you might borrow a payday loan for 3 months, which means the lender has 3 months to recover the costs of supplying the loan, whereas a mortgage is lent over 25-40 years, which means the bank has up to four decades to recover the costs of running their service.

Monthly instalments

As well as only borrowing for a short period of time, with most high cost short term credit, you make repayments on a monthly basis, and part of the repayment includes a portion of your loan principal (the amount you borrowed). Interest is charged on the loan principal, so as you make the monthly repayments, interest accrues on a smaller portion. This is why your repayments with some lenders might decrease over the length of your loan term.

Small loan amounts

Another reason the interest rate is often higher on short term credit is that the amounts you can borrow are much smaller than other credit options such as mortgages or personal loans from the bank. For example, 10% of £100 is £10, but 10% of £1000 is £100. While the interest rate is the same, the value is very different. This is why interest rates tend to be higher for smaller loans.

What to use instead of APR to calculate loan costs?

APR, or annual percentage rate, indicates how much you would need to repay if you borrowed a specified amount of money for 12 months, with no interim repayments. This is why it can be misleading when you look at credit which has monthly instalments and shorter loan terms. Payday loans are capped at a per annum interest rate of 292%, which works out to 80p per day per £100 borrowed, a much less scary figure than the annual percentage rate often quoted on lenders’ websites. If you want an accurate figure for how much a short term loan is going to cost you however, you should use the loan calculator on the lender’s website as this will tell you exactly how much you will need to repay in pounds and pence depending on how much you borrow and how long you borrow for.