4 Risks of Taking Out a Personal Loan
Personal loans can be a good fit if you have good credit, want fixed monthly payments and seek a predictable repayment process. However, the risks of personal loans may outweigh the benefits for some people, especially if they have poor credit or aren’t able to repay the loan.
4 risks of personal loans
If you’re considering a personal loan, it’s important to weigh the drawbacks that could arise depending on your financial position and creditworthiness.
1. Hurts your credit if you miss payments
If you don’t repay a personal loan, it can have a heavy impact on your credit score and can bring legal trouble into your life.
Typically, personal loans have a 30-day grace period until your lender reports a missed payment to one or more of the credit bureaus. However, during this time, your lender may charge you a late fee.
Once you pass 30 days of non-payment, your lender may report this to the credit bureaus which can cause your credit score to drop by 180 points. After 60 days, your lender may consider your account to be in default and forward it to their internal collections department.
If you haven’t made any payments after 120 days, your account may be sold to a third-party debt collection agency and there may be legal action taken against you. At this point, if you can’t repay your personal loan, you may have to consider debt settlement or bankruptcy.
2. High APR if you have bad credit
Whether you have a thin credit history or have some negative items on your credit report, if you don’t have a great credit score, you may get stuck with a high annual percentage rate (APR). This determines your total cost of taking out a loan, including interest rate and fees.
Because most personal loans are unsecured — meaning you don’t have to offer collateral — lenders rely heavily on factors such as your credit score to determine the likelihood that you’ll repay the personal loan.
If you have good credit, lenders may offer you a lower APR, meaning your overall cost of taking out a personal loan will be lower. On the other hand, if you don’t have great credit, to offset its risk, your lender may charge you a higher APR.
To qualify for lower APRs, work to improve your credit score to save yourself money in the long run if you plan to take out a loan.
| Credit band | Average APR |
|---|---|
| 720+ | 12.55% |
| 680-719 | 19.60% |
| 660-679 | 30.16% |
| 640-659 | 41.55% |
| 620-639 | 55.31% |
| 580-619 | 83.61% |
| 560-579 | 117.42% |
| Less than 560 | 158.87% |
Source: LendingTree user data on closed personal loans for the fourth quarter of 2022.
3. Fees to borrow (and pay back) money
When you take out a personal loan, you’ll likely have to pay the lender in order to borrow money. This is why you’ll be charged interest and fees.
For instance, many lenders charge a one-time origination fee — which is a type of processing fee — when you initially take out a loan. These can cost anywhere from 1% to 10% of the total loan amount and are typically taken out of your loan balance.
However, not all lenders charge these fees. If you have a robust credit score and history, you may qualify for no-fee personal loans.
4. Taking on unnecessary debt
Not every financial situation warrants taking out a personal loan. In fact, there are some instances where getting a loan could make your position even worse. Before signing on the dotted line for a personal loan, it’s important to weigh whether taking on new debt is right for you.
| When it makes sense to get a personal loan | When it may not make sense to get a personal loan |
|---|---|
You want to consolidate your debt into one fixed (and maybe cheaper) monthly payment You can get better terms by refinancing your credit card debt into a personal loan You can get better terms by refinancing your auto loan debt with a personal loan You have some wiggle room in your debt-to-income (DTI) ratio, like a small debt that’s easy to pay off | You want to pay for an unnecessary expense, such as a vacation You're already struggling to pay your monthly bills You can't qualify for reasonable terms on a personal loan, like a low APR Your DTI ratio is already higher than ideal |
Pros and cons of personal loans
When deciding whether or not you should take out a personal loan, consider the benefits and drawbacks that could arise when taking on more debt.
| Pros | Cons |
|---|---|
APRs are fixed so your minimum monthly payment will be the same each time Personal loans come with a clear repayment timeline so you'll know when your debt should be completely paid off Most lenders don't charge prepayment penalties so you can pay off your loan early without worrying about being penalized | If you don't have solid credit, you could be stuck paying high APRs Taking out a loan can increase your DTI ratio, which can add stress to your budget Some lenders charge origination fees, which can leave you with a smaller balance since it's typically taken out of your loan amount |
How to minimize the risks when taking out a personal loan
To really make a personal loan work for you, it’s important to know how to mitigate any potential risks even before meeting with lenders.
- Take a close look at your finances before you borrow. Use a personal loan calculator and evaluate your monthly budget to see if there really is room for a fixed personal loan payment. Generally, you’ll want to keep your debt-to-income ratio below 35% so you have wiggle room in your budget and can afford to pay your bills.
- Research lenders before you start shopping. Personal loan lenders are going to offer different rates, terms, fees and penalties, so it’s important to shop around and figure out which lender best fits your financial goals and position. For instance, some lenders specialize in fair credit loans, while others prefer to see borrowers with an excellent credit history.
- Shop around for the lowest APR for your financial situation. While personal loan lenders usually base APRs based on common factors like a borrower’s credit score and income, not all lenders will offer you the same APR. By comparing APRs, you can save yourself money over the lifetime of the loan. You can do this by prequalifying with different lenders.
Alternatives to personal loans
Depending on your credit and your financial situation, a personal loan may not be a good fit for you at this time. Instead, consider these alternatives:
Credit counseling
If you’re seeking a loan to better manage your current debts — such as a debt consolidation loan — instead of taking out new credit, consider seeking help in managing your debt with a credit counselor. Credit counselors can enroll you in a debt management plan and work with you on budget strategies to help you get out of debt at little to no cost.
Credit cards
Instead of a lump sum of money, a credit card can grant you access to a line of credit — up to a predetermined amount — that you can pull from as you need. If you have good credit, you may even qualify for a 0% intro APR credit card where you can forego interest for a set period of time.
Personal line of credit
This form of credit isn’t commonly offered, but you may have some luck accessing it through your current banker. A personal line of credit works like a credit card; however, unlike credit cards, it’s temporary and comes with draw and repayment periods.
Home equity loan or line of credit
If you own a home, you may consider using the equity you’ve built up by getting a home equity loan or line of credit (HELOC). While home equity loans work similarly to personal loans, HELOCs are more similar to personal lines of credit. The downside to these loans is that your home serves as collateral, meaning you could lose your home if you are unable to repay the debt.
401(k) loan
A 401(k) loan draws on the savings you have in your 401(k), so it’s like borrowing money from yourself. Details vary by plan, but you can generally borrow up to 50% of your savings (up to $50,000). Interest on a 401(k) loan goes right back into your account. Note that if you leave your current job, you may need to repay the loan right away — and if you default, it will be considered a withdrawal and you’ll be responsible for penalties and taxes on the borrowed amount.
Frequently asked questions
Paying off a personal loan could hurt your credit score because it minimizes your credit mix, which makes up about 10% of your FICO Score. This is relatively minor compared with other factors such as payment history, but having a lack of diverse credit products on your credit profile could negatively impact your score.
Taking out a personal loan may be a good idea if you have a low debt-to-income ratio, have a good credit score and can afford to repay the loan. Personal loans can come in handy particularly if you have an emergency expense and need to bridge the financial gap if you don’t have the money to pay for something up front.
If you’re already struggling to make ends meet and don’t have a strong credit profile, it may not make sense for you to take out a personal loan. Instead, consider improving your financial position and increasing your credit score.