Need a loan? There are plenty out there to choose from but the most straightforward is a personal loan, sometimes known as an unsecured loan. This is an open-ended loan that you are allowed to use for pretty much any purpose you want. You could pay off a higher-interest credit card, fund an adoption or pay for some other expense for which you lack the necessary funds. (Read also Different Needs, Different Loans.)
Before signing the agreement, however, you should consider the risks that accompany certain aspects of these loans.
1. 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 3 or 4 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.
Also, be careful when comparing annual percentage rates (APR). The APR can be manipulated. Instead, look at the total amount you will pay on the loan – including interest, fees and principal – over the life of the loan. That’s a better measure of the loan’s ultimate cost.
2. 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 lending, or by some other means – some lenders will be more favorably disposed to your paying off the loan early than others. If early payoff is important to you (and it should be), read the fine print closely to make sure that no penalty is involved. (Also, see "Precomputed Interest" below.)
3. 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.
4. 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.
5. 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.
6. 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.
7. Payday Loans
Payday loans are a form of personal short-term loan 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. (See also Beware of Payday Loans.)
8. 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.
The Bottom Line
Because most consumers aren’t skilled in the act of arbitrage, loans are almost always stacked in favor of the lender and not the borrower. If you are seeking a loan for a want rather than a need, consider saving for the purchase. If you decide to proceed with a personal loan, be sure you know the risks going in.