Pros and cons of small dollar loans: What to know before applying

Small dollar loans are short-term, low-cost loans banks and credit unions offer. They provide a federally regulated alternative to expensive payday loans or for borrowers who can’t qualify for low personal loan rates.  Banks and credit unions that offer them must follow strict rules to make sure they are affordable with maximum loan amounts of $2,500 or less.

Rather than credit scores, lenders base approval on your banking behavior and account standing. That means you may qualify for a small dollar loan if you manage your checking account well.

However, there are some drawbacks to weigh before applying for a small dollar loan.

Pros and cons of small dollar loans

Whether the pros outweigh the potential cons of a small dollar loan will depend on your financial needs and situation. Carefully consider how the potential outcomes could impact your long-term goals.

Pros

• Widely available.
• Easier qualifying standards.
• Fast funding.
• Comparatively low cost.
• Credit-building potential.

Cons

• Small borrowing amounts.
• Must have an active checking account.
• Not available at all lenders.
• Short payoff periods.
• Potential for scammers.

Advantages of small dollar loans

According to the Community Financial Services Association of America, 96 percent of borrowers found small dollar loans useful. Consumers often cite fast funding, low costs and the ability to build credit as positive small dollar loan benefits.

Widely available

CFSA data shows that approximately 12 million households use small dollar loans every year. They are available nationwide and regulated at the state level in 35 states.

As of April 2023, a Pew study found that six of the eight largest banks — operating nearly a quarter of all U.S. bank branches — offer small installment loans or line of credit options with much cheaper terms than payday loans.

Credit union members already benefit from the National Credit Union Administration’s (NCUA) Payday Alternative Loan programs. The program made $270.8 million in small dollar loans to consumers in 2023, a 20 percent increase over the previous four quarters.

Easier qualifying standards

A small dollar loan provides a reasonably priced option for consumers who don’t qualify for a personal loan. They’re available to borrowers across the credit spectrum and may be approved based on a review of your banking activity rather than your credit history.

That means rather than looking at credit history issues that may have happened years ago, they approve your loan based on the past few months of deposits and withdrawals. If you have regular deposits and withdrawals, the lender can review them to determine how much to lend you, allowing you to qualify even with a very low credit score.

Fast funding

Because the loans are federally regulated and approved based on your current bank account, you may be able to get funds the same day you apply. This is much faster than you might find with an online bad credit or payday lender.

It may take longer to receive money from a small dollar loan if you need to open a new account with a different bank or would prefer in-person assistance with the application. Ask your bank about their funding process so you know what to expect.

Comparatively low cost

The APR on a small dollar loan legally can’t exceed the 36 percent maximum or the limit set by the small dollar loan regulators in your state. That’s much less than the 115 to 650 percent APRs that typically come with payday loans.

Credit-building potential

Lending institutions that offer loans through the small dollar program must report your payment history to at least one of the three credit bureaus.

As you make consistent, on-time payments, your score may improve. This makes small dollar loans a great tool if you have damaged or no credit and wish to build a credit history or boost your score.

Disadvantages of small dollar loans

Some disadvantages come with taking out a small dollar loan, and they may not be a good fit if you need a higher dollar amount or live somewhere the program isn’t offered.

Small borrowing amounts

Small dollar loans can’t exceed $2,500, and many lenders set their maximums much lower. The six big banks reviewed in a recent Pew study capped amounts between $500 and $1,000. Some credit unions in the same study offered larger maximums between $1,500 and $2,000.

If you need more than that, you may need to seek an alternative, like a bad credit personal loan.

Must have an active checking account

If you don’t have a current checking account or have a lot of charges for insufficient funds or overdraft fees on your account, you may not qualify for a small dollar loan. Some banks and credit unions are more lenient regarding checking account requirements than others. Consider opening a second-chance checking account and ask them if they participate in small dollar loans.

As you deposit and withdraw funds from the account, you may be able to qualify for a loan in the future.

Not available at all lenders

Check with your local bank or credit union and ask if they participate in the small dollar loan program before you apply. If they do, they should offer all the advantages of small dollar loans outlined above. If not, you may need to take out a bad credit emergency loan or payday loan to make ends meet.

Short payoff periods

Most small dollar loans must be paid off in three to four months. While that’s much more time than the two- to four-week period to repay a payday loan, it may strain your budget if your income suddenly drops.

Some lenders may extend the repayment term to 36 months. Ask about extension options upfront if you earn variable income, such as tips or commissions.

Potential for scammers

Small dollar loans were created to combat short-term predatory lending. But searching for small dollar loans may lead you to ads for scams and predatory lenders. If you’re solicited by a company that says they’re from a major bank or credit union, you’re probably dealing with a scammer.

You should always be the one to call first or visit your local bank. Legitimate small dollar loans are only offered by federally regulated banks and credit unions. Pay specific attention to the fees and interest charged and look for Small Dollar Loan Program (SDLP) oversight.

How to decide if a small dollar loan is right for you

Before you choose a small dollar loan company, consider the following:

A small dollar loan is a good choice if:

• You need to borrow $2,500 or less.
• You have a checking account with regular deposits and no recent overdraft charges.
• You can afford to repay the loan in three to four months.
• You can’t qualify for a regular personal loan because of bad credit.

A small dollar loan is a bad choice if:

• You don’t have a checking account.
• Your income is unstable.

The bottom line

Small dollar loans can be a valuable tool for credit building and provide a low-cost alternative to payday and other bad credit loans. Make sure you can afford the monthly payments before applying. If you apply for a small dollar loan, work with a federally regulated bank or credit union. Beware of potential scammers.

If a small dollar loan is not the right fit for your financial needs, consider alternative options such as bad credit loans. But be aware you may take on greater costs and risks.