Life can throw a lot at you and there might be a few times in life where you will need to borrow money to pay for certain items that your current cash levels will just not cover. This can include the financing of a large item, covering medical expenses, consolidating debt, and so on. At these times it makes sense to borrow money and there are plenty of loans to choose from when you need financing. The most straightforward is a personal loan, sometimes known as an unsecured loan.
You can use this open-ended loan for pretty much any purpose you want. You could pay off a high-interest credit card, fund an adoption, or pay for some other expense for which you lack the necessary funds.
Before signing the agreement, however, you should consider the risks that accompany certain aspects of these loans. The following are the eight most common risks.
- Personal loans can help you pay for several types of large purchases but come with risks.
- Interest rates are based on your credit score.
- There can be a number of different fees attached to the loan.
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 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.
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 an early payoff is important to you (and it should be), read the fine print closely to make sure that no penalty is involved.
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. 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.
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 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.
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.