4 Risks of Taking Out a Personal Loan
If you’re consolidating debt or making a major purchase, a personal loan might look pretty attractive. It can be used to finance just about anything and comes in one lump sum, usually at a fixed, no-surprises interest rate.
But just like any other form of financing, personal loans come with their own set of benefits and risks. And depending on your financial situation, personal loan risks may actually outweigh the benefits.
In other words, it may not be time to shelve other financing tools — like credit cards — just yet. If you’re thinking of turning to a personal loan, read more below about the risks and how to mitigate them.
Ruining your credit if you can’t pay the loan
Personal loans are usually unsecured loans, and that means they don’t require collateral — like a home or car — in case you default. Instead, the loans are backed by your promise to repay the lender. Some personal loans, however, are secured by collateral like a savings account, or maybe a certificate of deposit. Borrowers usually turn to secured personal loans to boost their chances of getting a better interest rate — especially if their credit isn’t the best.
With both unsecured and secured loans, if you don’t consistently make your monthly payments, your credit history could take a hit. Just one late payment, for example, might cause your credit score to drop 100 points, and that’s enough to suddenly turn a “very good” credit score into one that’s just “fair.” If you wait even longer to make a payment, you could see another ding on your credit report.
Timeline: What happens when you don’t pay your personal loan
It doesn’t take long for a missed payment to show up on your credit report, and for lenders to cycle into action. However, many are often willing to work with borrowers who are struggling, so it’s key to call your lender as soon as you can. You might be offered a chance to temporarily stop payments, a lower interest rate or a longer loan term for paying back the debt.
Lenders react differently to missed loan payments, but here’s what you can expect if you suddenly stop paying your loan back:
- Days 30-60: Thirty days after your payment becomes delinquent, you’ll almost certainly hear from your lender, who may also charge a late fee. This is the time when your delinquency will be reported to the credit bureaus. When that happens, your credit score might drop significantly, even if you’ve always paid bills on time.
- Days 60-90: Your lender will probably continue trying to work with you, but will most likely report you to the credit bureaus again. Expect your credit score to take another hit.
- After 90 days: Your lender will contact you again, and may also start preparing to take you to court to recoup at least some of the money owed. This is the time to try to settle your debt, but for an unsecured loan you may see late fees and possibly a penalty interest fee. If your loan was secured and you lose your case in court, you will most likely lose any collateral you put up.
Getting stuck with a high APR
Before taking out any type of loan, it’s important to look closely at the annual percentage rate (APR), a measure of how much the loan will ultimately cost. The higher your APR, the more you’ll pay in interest and borrowing costs over the life of the loan.
Since personal loans are typically unsecured, lenders rely heavily on your credit score to determine your ability to pay back the loan. Borrowers who have excellent credit — say a FICO score of 760 or more — often receive the lowest APR on a personal loan compared to borrowers whose scores fall into lower credit bands. If your credit score is less than 670, it’s considered a subprime score, so it might become much harder to receive a competitive APR — and to fully pay off a loan according to the terms you’re given.
Luckily, personal loan interest rates aren’t determined solely by your credit score. Lenders typically also look for a steady income and a good debt-to-income ratio. However, if getting stuck with a high APR is a major worry for you, this might be the time to first work on improving your credit standing.
Here’s a look at the best average APRs offered to LendingTree users based on credit score:
|APR offers by credit score band|
|Credit score band||Average best offered APR|
|Source: LendingTree.com Personal Loans Offers Report, April 2020|
Comparing personal loan and credit card APRs
While personal loan APRs lean on the higher side for poor-credit borrowers, consumers with good credit can generally secure a lower APR with a personal loan than with a credit card, with the exception of cards with introductory 0% APR offers.
Credit cards issuers charge compounding interest on any balance that you don’t pay off each month. This is also known as a revolving balance. If you don’t carry a balance, you won’t be charged interest. But if you do carry a balance, the interest you pay will quickly increase your cost of borrowing.
A personal loan, on the other hand, is a lump sum loan that’s paid back with a fixed APR over a set repayment term. You’ll always know what you owe, and you don’t have to worry about racking up a balance.
Paying fees to borrow (and pay back) money
It’s generally a smart idea to only pay fees to borrow money if you’re going to save money in some other way, like getting a lower interest rate for the duration of the loan. This can get tricky with a personal loan, because your loan might look like it comes with a very appealing interest rate — until you notice it also comes with an origination fee and possibly also a prepayment penalty for paying off your loan early.
Origination fees for personal loans are basically processing fees assessed at the beginning of the loan; they typically cost 1% to 8% of the total loan amount. Not all lenders charge a loan origination fee, and prepayment penalties are rare. Fortunately for borrowers who have strong credit, many lenders now offer no-fee personal loans.
Taking on unnecessary debt
When you take on a personal loan, you risk taking on debt (depending, of course, on circumstances) that might have been avoided. However, not all debt is bad debt, and there are times when taking on debt is not only necessary, but might also be a smart money move.
Here’s a table that can help you decide whether your current financial situation warrants taking on more debt:
|When it makes sense to take on more debt||When it doesn’t make sense to take on more debt|
|You want to consolidate your debt into one fixed (and maybe cheaper) monthly payment||You want to pay for an unnecessary expense, such as a vacation|
|You can get better terms by refinancing your credit card debt into a personal loan||You’re already struggling to pay your monthly bills|
|You can get better terms by refinancing your auto loan debt with a personal loan||You can’t qualify for reasonable terms on a personal loan, like a low APR|
|You have some wiggle room in your debt-to-income ratio, like a small debt that’s easy to pay off||Your debt-to-income ratio is already higher than ideal|
How to minimize the risks when taking out a personal loan
To really make a personal loan work for you financially — and feel comfortable with your choice for the life of the loan — it’s important to know how to mitigate any potential risks even before meeting with lenders. Follow these steps to ensure you receive the best terms for your unique financial situation:
- Take a close look at your finances before you borrow. Check your monthly budget to see if there really is room for a fixed personal loan payment. If you’re already struggling to keep up with bills, this is the time to consider alternatives, like perhaps an unsecured personal line of credit or a peer-to-peer loan.
- Research lenders before you start shopping. Not all personal loan lenders operate in the same way, and you may find a loan online, through a bank or credit union or through a peer-to-peer lending situation. Some lenders specialize in loans for borrowers with fair credit, while others prefer to see an excellent credit history. Decide what you want out of a personal loan lender, and search personal loan lender reviews to find the best match.
- 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. It really does pay to compare.
One last note: Like any financing tool, personal loans can be used wisely or poorly, so take the time to fully research your options. By getting the knowledge to make an informed decision based on your financial needs, you might find a personal loan really is the best borrowing solution for you.