They may have a bad reputation, but there’s more to it than a black or white answer.
Short-term loans are designed to help borrowers meet their financial burdens until their next payday. However, given their high interest rates and quick turnarounds, they can often lead to a debt trap that may difficult to get out of.
Can short-term loans lead to bankruptcy?
It’s hard to know to what extent short-term loans play in bankruptcy, but statistics show that 11% of debt incurred by individuals seeking to file bankruptcy include a past short-term loan that has gone into default. But in general, a single short-term loan isn’t likely to cause you to go bankrupt.
However, borrowing for multiple short-term loans may be a sign of deeper financial instability. While they can provide some breathing room in an emergency, they can also overtake a paycheck that’s already spread thin. This is known as a debt cycle, which can be very difficult to find a way out of — thus leading many people toward bankruptcy.
What is the link between short-term loans and bankruptcy?
When borrowers who are already struggling with monthly expenses rely on short-term loans as a source of instant cash, the result is often more dire financial situation. What’s perceived as a one-time payday loan can easily turn into a long-term pattern of taking out high-interest short-term loans to pay steep finance charges and fees on previous loans.
According to a 2014 Consumer Financial Protection Bureau study, four out of five payday loans are rolled over or renewed in 14 days. And only 15% of borrowers pay their loan off on time without taking out another loan during that 14-day period. This “debt spiral” can lead a borrower to file for bankruptcy to stop the cycle.
Compare your short-term loan options to find a lender with competitive fees
What does it mean to default on a short-term loan?
When you default on a short-term loan, you’ve failed to make payments according to the contract you signed with a lender. Many lenders are forgiving, offering payment plans and extensions. But if you’re unable to repay your loan, you may default — which could lead to extra fees and even a visit to the court if your lender pursues legal action against you.
How to avoid defaulting on a short-term loan
Before taking on a short-term loan, work out a budget that ensures you can afford the loan within the repayment terms. If you don’t understand the terms and conditions fully, ask as many questions as you need until you do.
Keep in mind that a short-term loan should be a last resort for true financial emergencies only. Before you take on this high-cost financial product:
- Contact your creditors regarding existing loans. Your creditors or loan servicer may be willing to work with you to extend your due date or allow you to pay off your debt in installments.
- Call your bank or credit union. Banks and credit unions offer small loans that could take the pressure off your financial strain, depending on your account’s standing and credit history. One common option is a payday alternative loan from federal credit unions.
- Seek assistance from a community program or nonprofit. These organizations and programs are a great resource to help you develop a budget, obtain credit counseling and even tap into financial advances.
- Consider your credit cards or a pawn loan. Your credit card’s fees and terms may be better than what you can find with a short-term loan. As may a pawn loan, which allows you to use something of value for collateral until you can pay back what you’ve borrowed.
- Ask friends and family. Whether it’s a parent or a good friend, explaining your situation to a loved one and asking if they’re willing to give you an advance is a quick way to avoid a short-term loan. Plus, these usually come with no additional fees or interest.
You may also want to consider a few other short-term loan alternatives before jumping into a loan contract.
Short-term loans don’t necessarily lead to bankruptcy, but if you find yourself borrowing multiple loans just to keep your head above water, it might be a sign of deeper financial problems.
If you know you need a short-term loan, our guide on payday loans can help you compare your options so you can make an informed decision.