5 risks associated with taking out a personal loan
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Just as with any financial endeavor, there is risk associated with taking out a personal loan. As a borrower, it is important to be cautious of the amount of money you are taking out alongside your ability to pay it off. This is especially true as interest rates sit at higher-than-usual levels as the Federal Reserve continues to raise its base rate.
You receive a loan in the form of a lump sum. You then pay back the loan at a fixed interest rate over a set period, usually two to five years.
5 risks of taking out a personal loan
Consider the most common risks of taking out a personal loan and, more importantly, how to mitigate them.
1. Signing off on a steep APR
Interest rates vary greatly between lenders and your financial situation. This means that just qualifying for a personal loan does not make it a financially sound choice.
Interest rates are based primarily on your credit score, and the lower your credit score is, the higher your interest rate will likely be. Average rates can be as low as 10.73 percent for borrowers with an excellent credit score or as steep as 32 percent for borrowers with poor credit.
How to mitigate risk: Compare rates and look for lenders that consider other aspects, such as education or employment history.
2. Taking out too large of a loan
While it can be tempting to take out a large loan, be careful not to borrow too much. The larger the personal loan, the higher your interest rate will likely be. Along with this, a larger loan means longer repayment periods. With a longer repayment period, you will be stuck with more interest built up across the lifetime of the loan.
How to mitigate risk: Use a personal loan calculator to determine how interest can grow over the life of your loan and only borrow what you need.
3. Damaging your credit
Any missed payments will result in delinquency, which could damage your credit score. Since your credit score serves as a pillar in all aspects of your financial DNA, it is important to keep it in check.
Also be sure not to apply for too many credit accounts at once. Each time you apply, you will likely undergo a hard credit pull, which can negatively affect your score.
How to mitigate risk: Set up automatic payments for your loan to ensure you never miss a monthly payment. If you are comparing rates, apply for prequalification to avoid a hard credit pull.
4. Getting stuck with fees
A loan may seem perfect if it has a competitive interest rate and strong terms, but be sure to read the fine print to avoid hefty fees. Many lenders charge fees for the origination of the loan and some even charge extra for paying off your loan earlier than expected.
How to mitigate risk: Not all lenders disclose expected fees before you apply. Be on the lookout for them and ask about additional fees before submitting your application.
5. Falling into a debt spiral
Borrowing money from any source is putting yourself at risk of a debt spiral if you don’t have a plan. This is especially important to consider when taking out a personal loan for debt consolidation. Be sure that you are not entering a losing game by freeing up credit cards just to run them up again.
How to mitigate risk: Only agree to personal loan terms that you can truly afford so you do not end up building more debt. Also avoid using other open forms of credit while you pay back your debt.
How to use a personal loan responsibly
While there are a significant number of risks associated with borrowing any type of loan, there are ways to be responsible with the money you borrow. Provided you do your research, apply with reputable lenders and stick to a budget, you should be able to find a loan that fits your needs.
- Apply for what you need. Even if you can afford the monthly payment on a large loan, only borrow the minimum amount you need. This way, you don’t pay additional interest on money you could have done without.
- Check fees first. Origination fees, prepayment penalties and late fees can add up. Confirm the exact amount you will be expected to pay, and make your payments on time to avoid additional fees.
- Compare at least three lenders. Most lenders — including large banks — allow you to prequalify for personal loans. This allows you to check your rate without harming your credit score.
- Develop a budget. Similar to only borrowing what you need, have a budget in place to ensure you can consistently repay your loan. Additionally, be willing to reach out to your lender if there are any changes to your finances.
You should also have a specific purpose in mind when hunting for a personal loan. While a vacation can be expensive, it is not the most responsible reason to borrow. Home improvements, large bills and other unavoidable expenses are better ways to avoid overspending or borrowing what you can’t afford.
Approach the personal loan process with skill and forethought. Take the time to compare a variety of lenders, ranging from credit unions, banks, finance companies or lender networks. And pay close attention to the relationship between available rates and how interest may build over the lifetime of your loan.