Personal loans are versatile, which makes them attractive to consumers. You can use them to consolidate debt, finance a vacation or build a new addition on your home. But it’s not free money, so you should take seriously your decision to apply and investigate options before making a decision, says Tara Alderete, director of education for ClearPoint Credit Counseling Solutions.
“When you’re seeking a personal loan, think about why. What’s your goal? What do you want to do?” she says. If you can accomplish your goal by budgeting for it, that’s better than taking out a loan.
If you decide to borrow the funds you need, you should be wary of costly mistakes that could make a personal loan detrimental to your financial wellbeing.
1. Taking out a longer loan than necessary
A longer loan term means you’ll get a lower monthly payment. Here’s the catch: the lender will have more time to collect interest from you, which means the loan will be more expensive overall. Plus, personal loans with extended payment periods tend to have higher interest rates.
To illustrate, if you borrow $10,000 for 36 months at 7 percent, you’ll pay $308.77 per month and $1,115.75 in interest over the life of the loan. If you extend the loan term to 60 months, your monthly payment will drop to $198.01, but you’ll pay $1,880.72 in interest for the duration of the loan term. That’s a difference of $764.97 in interest.
So, it’s best to choose a personal loan with a shorter repayment term to avoid paying a fortune in interest. If you’re worried you can’t afford the monthly payment, use a loan calculator to determine a loan amount with a monthly payment that works for your budget. You may have to borrow less, but your wallet will thank you.
2. Not shopping around for the best offers
If you desperately need cash, it could be tempting to go with the first lender you find that approves you for a loan. Unfortunately, this could also be a costly mistake. There is no way to know if you’re getting the best deal or if there are better options out there.
For example, if your bank offers you a $15,000 loan for 48 months at 9 percent, you’ll pay $373.28 per month and $2,917.23 in interest for the loan term. But maybe the local credit union would’ve approved you for the same loan amount and term with a 5 percent interest rate, monthly payment of $344.44 and $1,581.09 in total interest costs. In turn, you would’ve saved $1,336.14 in interest over the life of the loan.
The upside of shopping around when you’re crunched for time is that there are ways to explore loan options from banks, credit unions and online lenders without impacting your credit score. You can use a loan matching tool to view potential offers in minutes. Some lenders also let you get pre-qualified online and view loan offers with no credit check.
3. Not considering your credit score
Lenders want to know that you can afford to repay what you borrow, which is why most require you to provide employment and income information. But there’s another factor that’s just as important: your creditworthiness or the likelihood of you paying back the loan on time.
The most competitive interest rates generally go to applicants with good or excellent credit scores. But if your score is low, you may get an exorbitant interest rate and spend several hundred or thousands more in interest. The lender might also deny your application.
Consequently, you should check your credit before applying for a personal loan to avoid any surprises. If your credit score is on the lower end, it’s worthwhile to explore other options to get the cash you need. In the meantime, review your credit report and file disputes if you notice inaccurate or outdated information that could be dragging your credit score down.
4. Overlooking fees and penalties
Some loans come with fees that could be costly if overlooked, including:
- Application fees are the amounts the lender charges prospective borrowers to apply for a loan.
- Late payment fees are the amounts you’ll pay if you remit payment after the cutoff time on the due date (or after the grace period).
- Origination fees are the processing fees assessed by the lender to set up the loan, and typically range from 1 percent to 8 percent of the loan amount.
- Prepayment penalties are the fees the lender charges if you pay the loan off early.
- Returned check fees are the penalties you’ll be charged if your payment is returned to the lender by your financial institution.
Most of these fees are avoidable if you make timely payments. You should also research lenders that don’t charge application or origination fees. Prepayment penalties can also be costly if you plan to pay your loan off early, so avoid lenders who assess this fee if possible.
5. Not reading the fine print
Before the loan is finalized, the lender will either send closing documents electronically or hand them to you for review. You must agree to the terms and conditions and sign the documents before the loan proceeds are disbursed to you.
Depending on the lender, there may be several pages to review and sign to close the loan. The fine print includes information regarding the calculation of interest, acceptable payment methods, due dates and the fee schedule. It will also say if the lender charges more for certain types of payments or automatically withdraws payments from your bank account on a certain day each month.
If you sign without reading, you could be in for an unpleasant surprise if the lender withdraws your first loan payment and overdraws your account. You’ll pay fees to your bank and the lender. Or maybe you decide to mail the first payment to the lender by check a week before it’s due, only to take a double-hit to your bank account when the payment is automatically deducted and the check is cashed. These are just a few of many things that could go wrong when you don’t read the fine print.
Bottom line
If you decide a loan is necessary, don’t make a decision in haste. That can prevent you from getting the cheapest financing available to you. It also could mean lenders will reject your application.
Ultimately, you want to shop around to find a loan with a competitive interest rate. It’s equally important that you get affordable monthly payments so you can pay the loan off in time and avoid costly consequences in the future.
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