6 Risks of Taking Out a Personal Loan
A personal loan could save the day when you find yourself facing financial hardship. With access to quick funds, you can consolidate debt, pay past-due bills or even cover the cost of an unexpected car repair.
Both secured and unsecured personal loans fix many financial problems in a short period, but as with any debt, there are a few risks to borrowing personal loans. Here’s what may make you think twice before signing on the dotted line.
1. Taking on debt you don’t need
Whether you need cash for life’s necessities, such as food and shelter, or optional expenses, such as a vacation or new TV, a personal loan can make it happen. But it’s important to remember that you are taking on costly debt to borrow this money.
Before applying for a personal loan, be sure it’s necessary. Is it possible that there is a more suitable option that has a smaller impact on your financial future, or is taking out a personal loan the only way to get the things you want and need?
2. Paying upfront fees to borrow money
Securing a personal loan often requires borrowers to do more than fill out an application and sign a few documents. If a lender wishes to charge the borrower upfront fees, this will be another requirement that will need to be satisfied before the disbursement of funds. These can include an origination fee, which is paid to the lender to cover the cost of processing the loan.
The amount owed for this fee, which will vary, can be paid by the borrower out of pocket or deducted from the principal loan amount. For example, personal loan lender LendingClub charges an origination fee of between 1 and 6 percent and deducts it from the loan amount before the borrower receives the funds. As you weigh the costs of your loan, be sure to include fees such as this.
3. Being punished for paying off your debt early
You’re expected to repay your personal loan by the end of the term, but, in some cases, you might be able to pay it off ahead of schedule. Doing so can save you money on interest. Unfortunately, you might be penalized for this.
Lenders have the option to charge borrowers a prepayment fee, which can be levied if a borrower repays their loan in full before the loan term has expired. This is not a hidden fee, so borrowers will be aware of this before accepting the loan. If paying off your loan early is part of your plan, select a lender that does not charge this fee.
4. Signing up for a variable rate when you shouldn’t have
Your lender may allow you to choose between a variable and a fixed rate for your loan. A fixed rate means that the loan’s interest rate will remain the same during the life of the loan. With a variable rate, the interest rate can change based on the rates of the market. Though the variable rate may be lower than the fixed rate when you sign up for a loan, you might later be making higher payments if the interest rate rises.
When trying to determine if a fixed- or variable-rate loan is better, borrowers will want to consider the following:
- Income: If you have a limited, set income, you know what you can afford every month. If you can’t afford for your monthly payment to increase later, a fixed-rate loan may be a safer option.
- How quickly you’ll repay the loan: The longer it takes to repay your personal loan, the greater your chances are of seeing your rate increase. If you plan to repay your loan quickly, a variable rate might not change much.
- Budget: A monthly budget is easier to manage when income and expenses are the same month after month. Budgeting can be difficult when there is the possibility of your personal loan payment fluctuating, making a variable rate seem the least favorable option between the two.
5. Getting caught with a high APR
Lenders attract borrowers by advertising low interest rates for their personal loans. But these lower rates are typically reserved for those who have excellent credit — anyone with less than perfect credit is offered a higher interest rate or denied completely.
If you decide to apply for a personal loan, it’s best to research and compare multiple offers from different lenders. LendingTree found that consumers can save as much as 35 percent if they compare interest rates before accepting a loan offer. Should you find a promising lender, carefully review the loan documents to get a clear understanding of just how much the loan will cost you.
6. Confusing a payday loan for a personal loan
There is a lot of confusion surrounding payday loans and personal loans. Borrowers should be aware of the differences between the two so that they can make the right decision during their time of need.
A few key differences between personal loans and payday loans:
- Terms: Payday loans are short-term loans that are expected to be repaid on the borrower’s next payday. A personal loan will have a longer term that may not lapse for years.
- Loan amounts: Payday loans are often for smaller amounts. Many borrowers will find they are only able to borrow up to $500. When choosing a personal loan, however, borrowers could have access to thousands of dollars if the lender approves their application.
- Credit check: A traditional requirement of borrowers who wish to secure a personal loan is that they are creditworthy. Reputable personal loan lenders will use an applicant’s credit score to assist them in determining if they will approve the loan, how much money they can borrow and what their interest rate will be. Payday lenders often don’t check the borrower’s credit before approving them for a loan because the only thing typically required of borrowers is verification of identification, an active bank account and a reliable source of income.
Since selecting a payday loan can result in more harm than good, it would be wise for people to steer clear of payday lenders if possible.