When you take out a short-term loan, the agreement you sign outlines more than just the interest rate and due date. It also details penalties that apply if you fail to meet the terms. These fees vary by lender and state regulations but are most often triggered by late or missed payments.
When a penalty is applied, the lender adds it to your outstanding balance. This means you begin paying interest on the penalty itself, a process known as capitalization. This can quickly increase your total debt, making it difficult to catch up.
Common Types of Short-Term Loan Penalties
Short-term lenders use penalties to offset the risk of lending to borrowers who may have poor credit. Understanding these common charges is essential before signing a loan agreement.
- Late Payment Fees: This is the most frequent penalty. If you miss your payment due date, the lender will charge a fee. This can be a flat amount (e.g., $30) or a percentage of the payment.
- Rollover or Extension Fees: If you cannot repay your loan on time, some lenders may offer to “roll over” the debt into a new loan. While this extends your deadline, it comes with a new finance fee, essentially repeating the initial cost of borrowing without reducing the principal you owe. This is a primary cause of the payday loan debt trap.
- Non-Sufficient Funds (NSF) Fees: If you authorize an automatic payment and lack sufficient funds in your bank account, the transaction will fail. Your bank may charge you an NSF fee (typically $30-$35), and the lender will often charge a separate returned payment fee, hitting you with two penalties for a single failed payment.
- Prepayment Penalties: While less common for payday loans, some installment loans may include a prepayment penalty. This is a fee for paying off your loan ahead of schedule, designed to compensate the lender for the interest they would have otherwise earned.
- Collection Fees: If you default on the loan, the lender may transfer your account to a collections agency. The costs associated with the collection process can be added to your total debt, further damaging your credit score.
How to Avoid Short-Term Loan Penalties
The best strategy is to avoid penalties entirely. Here are five practical tips:
- Read Your Loan Agreement: Before signing, carefully review the terms and conditions. If you don’t understand something about the fees, interest, or penalties, ask the lender for clarification.
- Confirm You Can Afford Repayment: Map out a budget to ensure you will have enough money to repay the loan on its due date without needing to roll it over.
- Set Payment Reminders: Make repaying the loan a top priority. Use calendar alerts or other reminders to ensure you don’t forget the due date.
- Build an Emergency Fund: The best long-term solution is to build an emergency fund. Having even a few hundred dollars in savings can eliminate the need for high-cost loans in the first place.
- Explore Alternatives: Before taking a short-term loan, look into a payday loan alternative. A personal loan from a credit union, a credit-builder loan, or a cash advance from an employer may offer better terms and lower costs.
Source:
- Consumer Financial Protection Bureau (CFPB). “What are the risks of taking out a payday loan?” https://www.consumerfinance.gov/ask-cfpb/what-are-the-risks-of-taking-out-a-payday-loan-en-1567/
