One of the easiest ways to borrow money when you need it is through a personal loan, also referred to as an unsecured loan. You can use this open-ended loan for almost anything you want, but you should think about the risks involved with some aspects of these loans before you sign the agreement. The following are the eight most common risks.
Taking out a loan can be a great way to finance a large purchase or consolidate debt, but it’s important to be aware of the risks involved before you sign on the dotted line Here are some of the main risks to consider:
1. High Interest Rates
The loan interest rate that you will be charged is determined by your credit score. A low credit score may result in you paying a much higher interest rate, but a high credit score will typically qualify you for a lower rate. Make sure to thoroughly review the loan’s interest rate if you’re thinking about taking out a loan because you can’t be accepted for a less expensive financial product, like a credit card with a low introductory rate.
2. Prepayment Penalties
Prepayment penalties are fees that are imposed when you pay off a loan before it is due. Some lenders charge them to help make up for the money they expected to earn from interest charged on the loan. The best way to know if a loan has a prepayment penalty is to ask the lender directly They must be disclosed, but sometimes that disclosure could be in the fine print of your loan documents
3 Origination Fees
Origination fees represent a portion of the loan amount that the lender assesses as a necessary business expense. While not all lenders charge them, those who do sometimes charge higher interest rates. Origination fees can be up to 15% of the amount borrowed. An origination fee could be deducted from the amount you receive or added to the loan balance. In the event that, for instance, you borrow $10,000 and pay a 5% origination fee, you could receive $9,500 or possibly owe $10,000. Be sure you understand how that will work, and plan accordingly.
4. Higher Overall Debt
If you take out a personal loan to consolidate credit card debt, it’s smart to try to get a lower interest rate—but that should not be your only consideration. If a credit card with plenty of available credit tempts you to overspend and you charge it up again, you could wind up with more debt than when you started. However, if a debt consolidation loan is part of an overall plan and you have addressed the habits that led to high credit card debt, it can be a good idea.
5. Damage to Your Credit Score
Every time you apply for a loan, the lender will do a hard inquiry on your credit report. This can temporarily lower your credit score by a few points. If you’re already struggling with a low credit score, it’s important to be careful about how many loans you apply for.
6. The Interest Rate
Just because you qualify for a personal loan doesn’t mean you should take it. Some personal loans come with interest rates well below 10%, while others may be three or four times higher. The interest rates on these loans depend on your credit score, but lenders may charge whatever they want, provided the rate falls within certain laws.
7. Early-Payoff Penalties
Are you allowed to pay the loan off early or is there a penalty or fee for doing so? Depending on which kind of personal loan you get—from a bank, via peer-to-peer (P2P) lending, or by some other means—some lenders will be more favorably disposed to your paying off the loan early than others. If an early payoff is important to you (and it should be), read the fine print closely to make sure that no penalty is involved.
8. Big Fees Upfront
How much will it cost you to get the loan money into your bank account? As with a mortgage, upfront origination fees for the loan can vary widely. You want to ensure that any upfront fees you are paying are fair and in line with market levels. There are many providers out there with varying terms, so don’t feel like you have to take the first loan that you are approved for.
9. Privacy Concerns
Bank and credit union loans will come with strict privacy rules, but other options may be considerably less formal. Although all lenders should respect privacy laws similar to those required for banks, some may not.
10. The Insurance Pitch
Some personal loans will come with a sales pitch for additional insurance to protect the loan in case “life’s unexpected events” get in the way of your ability to repay. If you want insurance for that purpose, call an agent you trust and get a quote on general disability insurance. It’s probably cheaper and has better coverage.
11. Precomputed Interest
Basically, precomputed interest uses the original payment schedule to calculate your interest regardless of how much you’ve actually paid on the loan. Simple interest looks at what you owe today and computes your interest on that figure. Make sure to ask the lender how the interest is being computed. If you hope to pay off the loan early, you want simple interest.
12. Payday Loans
Payday loans are a form of short-term personal loans that financial gurus and government agencies advise consumers to avoid. The interest rates are very high, and the terms often force people into rolling over the loan for additional terms.
13. Unnecessary Complications
A loan is a simple product. Someone gives you money and you pay it back with interest. If a company offers you payment holidays, cash back offers, or other enticements, understand that the company is not going to lose money on the deal. The only possible loser is you. A personal loan should be simple to understand. If it’s not, that’s a red flag.
How to Minimize the Risks of a Personal Loan
Tempting as it is to apply for a loan because you need something now but you don’t have the cash, take a minute to think some things through. For example:
- Review your budget to be sure you have enough room to add a payment, and what the maximum size of that payment could be.
- Shop around for a personal loan. Such loans are offered online, at banks and at credit unions. You might want to start with credit unions, because they are not-for-profit and tend to have lower rates and fees.
- Consider setting up autopay if you get approved for the loan. Be sure to use an account that reliably has enough money in it to make payments so you don’t overdraw your account. On-time payments are crucial, because a payment reported as 30 days late can devastate your credit score.
The Bottom Line
A personal loan can be a useful financial tool, but not all personal loans are exactly alike. If you’re looking to apply, check interest rates, fees and prepayment penalties. Then make sure your budget has room for the new payment and that you have a solid plan for paying on time, every time.
Additional Resources
- Experian: Risks of Taking Out a Personal Loan
- Investopedia: 8 Possible Risks of Unsecured Personal Loans
Frequently Asked Questions
Q: What is the biggest risk of taking out a personal loan?
A: The biggest risk of taking out a personal loan is that you won’t be able to repay it. This can damage your credit score and make it difficult to borrow money in the future.
Q: How can I minimize the risks of taking out a personal loan?
A: You can minimize the risks of taking out a personal loan by shopping around for the best interest rate, making sure you can afford the payments, and paying off the loan as quickly as possible.
Q: What should I do if I can’t afford to repay my personal loan?
A: If you can’t afford to repay your personal loan, you should contact your lender as soon as possible. They may be able to work with you to create a payment plan that you can afford.
How Do People Use Personal Loans?
Investopedia commissioned a national survey of 962 U. S. adults between Aug. 14, 2023, to Sept. 15, 2023, to find out how they used the money from their personal loan and how they planned to use additional personal loans. Debt consolidation was the most common reason people borrowed money, followed by home improvement and other large expenditures.
The Interest Rate
Just because you qualify for a personal loan doesn’t mean you should take it. Certain personal loans have interest rates that are well below 2010 percent, but others could have rates that are three or four times higher. Your credit score determines the interest rate on these loans, but lenders are free to set any rate they choose as long as it complies with legal requirements.
Also, be careful when comparing annual percentage rates (APR). The APR can be manipulated. Rather, consider the entire amount you will pay for the loan over its entire term, including principal, interest, and fees. That’s a better measure of the loan’s ultimate cost.