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- High rates can make loans much more expensive, especially if you opt for a longer term to keep monthly payments low.
- Larger loans can be difficult to handle — or qualify for — if you don't have the income to cover payments.
- Origination fees, early payoff fees and late fees can quickly add to the total cost of a personal loan.
- Only borrow what you need and focus on making payments to keep costs down and your credit score intact.
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 while interest rates sit at higher-than-usual levels as the Federal Reserve continues to raise its base rate.
How does a personal loan work?
You receive a loan in the form of a lump sum. You then pay back the loan at a fixed or variable 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 between lenders and depend largely on your financial situation. Just qualifying for a personal loan does not make it a financially sound choice.
Interest rates are based primarily on your credit score. The lower your credit score is, the higher your interest rate will 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 of your finances, such as your 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 life 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. Work on your budget, calculate costs and take the time to improve your credit score before you start submitting applications. Once you know the more common risks, you will be able to choose a personal loan that fits your needs and limits your chance of default.